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The Fed That Ate the World.

Latest news is that the Fed will take over the commercial paper market. Big corporations raise funds by selling debt securities as well as borrowing from banks. But no one wants to buy these securities—"commercial paper"—because no one knows whether the corporations can pay them back. So big corporations like GE suddenly find themselves unable to obtain the funds that they need to meet payroll, make investments, and so forth. In steps the Fed. The Fed will buy up the commercial paper for the time being. If all goes well, the Fed will hold it to maturity or sell it if anyone ever decides to buy it, and the government will not lose any money. If all doesn't go well, the Fed can wallpaper its offices with trillions of dollars of notes.

As David Zaring notes, the commercial paper market, worth $1.6 trillion, is even bigger than the $700 billion borrowing authority contemplated by the bailout bill. Yet no one seems to think that the Fed needs new statutory authority to risk trillions, rather than merely hundreds of billions, of dollars. Why not?

Section 13(3) of the Federal Reserve Act authorizes the Fed to lend money to businesses in "unusual and exigent circumstances." This section was the same one that the Fed used for the AIG deal. There may be some uncertainty whether it is proper for the Fed to make unsecured loans to businesses (and apparently to avoid the appearance of doing so the Fed is lending to a new entity that will buy the commercial paper rather than buying the paper itself), though the statute appears to permit it. But section 13(3) would also permit the Fed to buy up mortgage-backed securities from firms. So the question is, if section 13(3) is the all-powerful authority for everything, why did the Fed bother with the bailout bill? As far as I can tell, the bailout bill was necessary because the Fed and Treasury put their heads together and decided that Treasury should buy the MBS's, and for that, a statute was needed. But was it worth such hullabaloo to give Treasury authority that the Fed already had?

We are in the realm of psychology, maybe political psychology, not law, and not even economics. The Fed, and maybe Treasury, already have all the authority they need to take over the banking system—or I should say the functions that the banks and investment banks once served. It was important for the Fed and Treasury to get to the markets some signal that Congress backed them, but it really didn't matter what exactly Congress authorized, as long as its authorization bore some relationship to whatever it was that the Fed and Treasury would eventually decide to do. After all, only Congress has the authority to raise money to pay back U.S. government debts, so it would be nice to know that Congress is more or less on board. On this view, the great debate about the bailout bill -- what it did, and did not do, and what it should have done, or not done -- entirely missed the point. Treasury and the Fed will decide how to address this financial crisis. A broad congressional endorsement is nice, but Congress had nothing of substance to contribute to policy. Other than the handouts to special interests, I will bet my portfolio of mortgage-backed securities that nothing in that statute will have any impact on how the financial crisis is addressed.

titus32:
Interesting post. However, to the extent the Fed continues to take on large-scale projects (like buying commercial paper), doesn't the "signal" sent to the market by the Bailout Bill (i.e., that Congress would repay the government's obligations) weaken? By signing on to the Bailout Bill, Congress has only "committed" to the $700 million involved in the bailout -- it has not signed a blank check.
10.7.2008 5:21pm
Mahan Atma (mail):
"By signing on to the Bailout Bill, Congress has only "committed" to the $700 million involved in the bailout -- it has not signed a blank check."


It's billion, not million. You're only off by a factor of a thousand.
10.7.2008 5:24pm
Sua Tremendita (mail):
Time to be afraid. The Feds are doomed to repeat its failures.
10.7.2008 5:25pm
Adam J:
At least this doesn't involve helping out the bad actors in this disaster. However, I wonder whether the commercial paper market is truly seizing up, or whether its merely that interest rates have increased beyond what companies would like to pay (thanks to the increased risk).
10.7.2008 5:26pm
Kurt M. (mail):
10.7.2008 5:26pm
titus32:
Mahan: you're right -- but my typo is immaterial to my point. If it makes you feel better, here's my new comment:

Interesting post. However, to the extent the Fed continues to take on large-scale projects (like buying commercial paper), doesn't the "signal" sent to the market by the Bailout Bill (i.e., that Congress would repay the government's obligations) weaken? By signing on to the Bailout Bill, Congress has only "committed" to the $700 billion involved in the bailout -- it has not signed a blank check.
10.7.2008 5:28pm
Morat20 (mail):
Commercial paper isn't terribly risky. It's loans with a term of less than a month, which the Fed will be lending and recovering at rates above the prime rate.

The size they're talking about isn't like a bailout -- wherein the money is gone for years until assets are resold and some costs (if you're lucky, you break even when accounting for inflation) recovered.

This is just sheer liquidity, money flowing back and forth. From a purely fiscal standpoint, this is a much better thing to do than a bailout as the outlays are very short-term -- from an economic standpoint, it's a pretty nasty sign that the market has truly locked up.

The market for commercial paper isn't a high-reward one, the profits are slim, but they are steady and very low-risk. Ironically, the Fed will probably make a decent chunk of change off this.
10.7.2008 5:28pm
jim (mail) (www):
Why the TARP? Presumably because Bernanke didn't want to play. There's a check and balance going on here. The Fed has enormous formal authority to act, but not much money; the Treasury has lots and lots of money, but no authority to act without enabling legislation. If the Fed and Treasury agree, they can act together: the Fed will buy commercial paper; the Treasury will make a "special deposit" at the NY Fed to supply the cash. But if Bernanke didn't want to use his authority to buy MBSs and such, the Treasury couldn't make him. Paulson had to go to Congress to get authority to act on his own.
10.7.2008 5:45pm
Opher Banarie (mail) (www):

...the Fed can wallpaper its offices with trillions of dollars of notes.

Maybe we'll see some new inventory of gag gifts stuffed with shredded commercial paper rather than Federal Reserve Notes! That industry is ripe for some innovation.
10.7.2008 5:58pm
ChrisIowa (mail):
Was that 700 American Billion or British Billion?
10.7.2008 6:26pm
Michael B (mail):
Another vantage point, oil has fallen from a high of $140/barrel to $90/barrel most recently, is $40/barrel in the offing?
10.7.2008 6:45pm
Don Miller (mail) (www):
In a large way, the credit market is locked up on fear and speculation right now.

I am not a fan of the Fed getting involved in commercial paper, but if they move into the market, they probably don't have to buy all of it. Any significant percentage will hurt the margins of the current players and they will relax a little bit and start buying it up themselves again.

/just guessing like everyone else.
10.7.2008 7:24pm
gab:
Buying mortgages is not the same as "lending to corporations." Perhaps it's as simple as that.
10.7.2008 7:42pm
AllenCharles (mail) (www):
Last time I researched it the New York Federal Reserve Bank was worth about 21 trillion. Probably more now?
10.7.2008 8:08pm
Dave N (mail):
If, indeed, the commercial paper market is seizing up, then on a short-term basis this makes sense.

One of the larger (if not largest) buyers of commercial paper are money market mutual funds. The funds are concerned that they will "break the buck" as the Reserve Primary Fund recently did as a result of the Lehman Brothers collapse.

If more money market mutual funds "break the buck," (which I fervently hope does not happen), the short term capital markets will dry up completley as investors abandon money markets in droves.
10.7.2008 8:20pm
Soronel Haetir (mail):
I can see the desire for Treasury doing the bailout so that it is kept under political control. The Fed is far too independant for the pols to be comfortable with that. At least if Treasury screws up heads can roll.
10.7.2008 8:38pm
A. Zarkov (mail):
I'm afraid most people don't see the larger issue. American business is too dependent on debt financing. In fact many businesses are kept on life support by constant infusions of new debt. It's like New York City in the 1970s. It kept financing itself by rolling over its debt with new issues. Finally no one wanted to buy its paper any more and the city went into default. This happening all over again on a national, and even international scale. The Fed and the Treasury keep trying to fix a debt problem with more debt, and as one can see it doesn't work. We kept borrowing from the future and unfortunately the future is now.
10.7.2008 9:04pm
Waldensian (mail):

One of the larger (if not largest) buyers of commercial paper are money market mutual funds. The funds are concerned that they will "break the buck" as the Reserve Primary Fund recently did as a result of the Lehman Brothers collapse.

Although your point is taken, the Reserve Primary Fund had problems because it held $785 million in bonds issued by Lehman Brothers. There's not a a lot of reason to think that funds like Vanguard's or Fidelity's have equivalent exposure. At least not yet.
10.7.2008 9:12pm
Harry Eagar (mail):
Man, are these guys making it up as they go along.

Everybody who predicted that the USG would take over the commercial paper market, raise your hands!
10.7.2008 10:33pm
Oren:

If more money market mutual funds "break the buck," (which I fervently hope does not happen), the short term capital markets will dry up completley as investors abandon money markets in droves.

Abandon it in favor of what? Wherever they put cash (government bonds, savings accounts) they will be available to be loaned.
10.7.2008 11:47pm
Dave N (mail):
Oren,

I can imagine people hording cash or converting to precious metals as a hedge against inflation if the markets truly melt down. And not all alternatives are as liquid as others.
10.8.2008 1:15am
Dave N (mail):
Waldensian,

My understanding is that the Reserve Primary Fund had something like $65 billion in assets. So it was not a small player among money market mutual funds. As the article I linked to notes, the fund lost 3 cents a share on the basis of suddenly having several hundred million in suddenly worthless Lehman Brothers short-term debt.

I am not sure if Fidelity and the other giants have controls in place to prevent what happened with Reserve Primary or whether they were just lucky.
10.8.2008 1:19am
Oren:
Dave,

Too much cash chasing too few commodities and metals will eventually push them around to bonds/FDIC savings.
10.8.2008 1:39am

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