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.
It's billion, not million. You're only off by a factor of a thousand.
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.
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.
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.
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.
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.
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.
Everybody who predicted that the USG would take over the commercial paper market, raise your hands!
Abandon it in favor of what? Wherever they put cash (government bonds, savings accounts) they will be available to be loaned.
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.
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.
Too much cash chasing too few commodities and metals will eventually push them around to bonds/FDIC savings.
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