Global Post-Crisis Economic Outlook
Henry C.K. Liu

Part I:   Crisis of Wealth Destruction   
Part II:  Two Different Banking Crises - 1929 and 2007
Part III: The Fed’s No-Exit Strategy


Part IV: The Fed’s Extraordinary Section 13(3) Programs

This article appeared in AToL on April 23, 2010

During the financial crisis, the Federal Reserve resorted to extraordinary meta-monetary measures. On March 11, 2008, the Fed announced an expansion of its securities lending program and arranged the Term Security Lending Facility (TSLF) to provide secured loans collateralized with Treasury securities to the 18 primary dealers for 28 day terms.
On the same day, the Federal Open Market Committee (FOMC) authorized increases in its existing temporary reciprocal currency arrangements (swap lines) with the European Central Bank (ECB) and the Swiss National Bank (SNB).  These arrangements provided dollars in amounts of up to $30 billion and $6 billion to the ECB and the SNB, respectively, representing increases of $10 billion and $2 billion.  The FOMC extended the term of these swap lines through September 30, 2008
Under this new TSLF, the Fed would lend up to $200 billion of Treasury securities to primary dealers for a term of 28 days (rather than overnight, as in the existing program) secured by a pledge of other securities, including federal agency debt, federal agency residential-mortgage-backed securities (MBS), and non-agency AAA/Aaa-rated private-label residential MBS.  The TSLF was intended to promote liquidity in the financing markets for Treasury and other collateral and thus to foster the functioning of financial markets more generally.  As was the case with the current securities lending program, securities would be made available through an auction process.  Auctions were held on a weekly basis, beginning on March 27, 2008.  The Fed consulted with primary dealers on technical design features of the TSLF to fit their funding needs.
TSLF was a weekly loan facility that promoted liquidity in Treasury and other supposedly high-rated collateral markets and thus fostered the functioning of financial markets more generally. The program offered Treasury securities held by the System Open Market Account (SOMA) for loan over a one-month term against other program-eligible general collateral. Yet the qualifying credit ratings of the acceptable collaterals were mostly based on mark-to-model, since primary dealers holding of high-rated collaterals mark-to-market had no need to borrow from TSLF. Securities loans were awarded to primary dealers based on a competitive single-price auction. Obviously, primary dealers in deepest stress would bid the highest single-price for loans.
The TSLF was announced on March 11, 2008, and the first auction was conducted on March 27, 2008. The TSLF was closed almost two years later on February 1, 2010, but the Fed said it may resume if market conditions warrant. By market conditions, the Fed meant when a gap again develops between mark-to-market values and mark-to-model values that creates distress for primary dealers. Thus TSLF was really a facility to support primary dealers on more than liquidity distress.
The SOMA Securities Lending program offers specific Treasury securities held by SOMA for loan against Treasury GC (general collateral repos) on an overnight basis. Dealers bid competitively in a multiple-price auction held every day at noon. The TSLF would offer Treasury GC held by SOMA for a 28-day term. Dealers would bid competitively in single-price auctions held weekly and borrowers would pledge program-eligible collateral.
In contrast to the Term Auction Facility (TAF) which offered term funding to depository institutions via a bi-weekly competitive auction, the TSLF offered Treasury GC to the New York Fed’s primary dealers in exchange for other program-eligible collateral.  The New York Fed term repo operations are designed to temporarily add reserves to the banking system via term repos with the primary dealers.  These agreements are cash-for-bond agreements and have an impact on the aggregate level of reserves available in the banking system. The security-for-security lending of the TSLF, however, would have no impact on reserve levels since the loans were collateralized with other securities.
Primary Dealer Credit Facility (PDCF)
On March 16, 2008, invoking authority under the rarely used Section 13(3) of the 1932 Federal Reserve Act, the Fed established temporarily the Primary Dealer Credit Facility (PDCF) to provide allegedly fully secured overnight loans to primary dealers. Primary dealers are banks and securities brokerages that trade in US Government securities with the Federal Reserve System. As of September 2008, there were 19 primary dealers. Daily average trading volume in US Government securities by Primary dealers was approximately $570 billion during 2007. PDCF was an overnight loan facility that provided funding to primary dealers in exchange for any tri-party-eligible collateral and was intended to foster the functioning of financial markets more generally.
PDCF differed from other Fed facilities in the following ways. The Term Auction Facility program (TAFP) offered term funding to depository institutions via a bi-weekly auction, for fixed amounts of credit. The Term Securities Lending Facility (TSLF) was an auction for a fixed amount of lending of Treasury general collateral in exchange for Open Market Operations (OMO)-eligible and investment grade (AAA) corporate securities, municipal securities, mortgage-backed securities, and asset-backed securities.
Fed credit advanced to the primary dealers under the PDCF increased the total amount of bank reserves in the financial system, in much the same way that Discount Window loans do. To offset this increase, the OMO Desk utilized a number of tools, including, but not necessarily limited to, outright sales of Treasury securities, reverse repurchase agreements (reverse repos), redemptions of Treasury securities and changes in the sizes of conventional reverse repo transactions.
But PDCF credit differed from discount window lending to depository institutions in a number of ways. The discount window primary credit facility offers overnight as well as term funding for up to 90 calendar days at the primary credit rate secured by discount window collateral to eligible depository institutions. The primary credit facility at the discount window, as revised by the Federal Reserve in 2003, offered credit to financially sound banks at a rate100 basis points above the Federal Open Market Committee’s target federal funds rate (the primary credit rate).
Primary credit was made available to depository institutions at an above-market rate but with very few administrative restrictions and no limits on the use of proceeds. Because the interest rate charged on primary credit was above the market price of funds, it replaced the rationing mechanism for obtaining funds from the central bank and eliminated the need for administrative review by the Federal Reserve.
Amid the onset of the liquidity crisis in August 2007, the Federal Reserve lowered the spread between the primary credit rate and the target funds rate from 100 basis points to 50 basis points and extended the maximum term of loans to thirty days.
In March 2008, the Fed once again narrowed the spread, this time to 25 basis points, and extended the loan term to 90 days. The moves were motivated by the desire to make discount window credit more accessible to depository institutions.
The Fed’s actions led to an increase in the volume of discount window borrowing during the crisis. While the massive increase in the volume of borrowing supports the argument that the stigma of borrowing had been eliminated, one should be cautious when interpreting this result. Despite the expansion in borrowing, some trades in the funds market took place at rates above the primary credit rate.
Reluctance of banks to borrow from the Fed discount window has several components. The non-price mechanism is the component attributable to the Fed’s implementation of discount lending. This component declined significantly after the establishment of the revised facility in 2003.
Meanwhile, a second type of stigma arises from the asymmetric information problems associated with discount window borrowing. Specifically, while most banks borrow from the discount window, the facility is also used by troubled or failing institutions. Because market participants cannot fully differentiate sound from troubled borrowers, they may view borrowing as a potential sign of weakness of any bank that visits the discount window. If this type of stigma increases at the early stages of a financial crisis, when institutions are trying to signal their good health, it could explain the spikes in the funds rate over the primary credit rate. In addition, it is plausible that the capital crunch during the financial crisis left some institutions without sufficient collateral to apply for primary credit loans and thus forced them to bid for higher rates in the federal funds market, which is un-securitized.
The PDCF, by contrast, was an overnight facility available to primary dealers (rather than depository institutions). PDCF expired on February 1, 2010.
Since not all primary dealers are depository institutions, the Fed, to provide credit assistance to them, had to invoke authority under Section 13(3) of the 1932 Federal Reserve Act, as amended by the Banking Act of 1935 and the FDIC Improvement Act of 1991, which permits the Fed to lend to any individual, partnership, or corporation “in unusual and exigent circumstances if the borrower is “unable to secure adequate credit accommodations from other banking institutions.”
Section 13(3) was enacted in 1932 out of concern that widespread bank failures would make it impossible for many firms to obtain loans, thus depressing the economy. In the four years after the Section was added, the Fed made a total of 123 loans totaling just $1.5 million. Section 13 (3) was not used again until 2008, 76 years later.
In addition to applying Section 13(3) to PDCF, the Fed also invoked it to authorize the NY Fed to lend $29 billion to a newly created special limited liability corporation named Maiden Lane, LLC) to exclusively facilitate the Fed/Treasury-sponsored JP Morgan Chase acquisition of Bear Stearns which faced imminent insolvency from bad investments in subprime mortgage securities extensively funded by overnight repos that were unable to rollover.
The PDCF and the Maiden Lane loan departed significantly from the Fed’s normal practice of lending only to financial sound institutions against top-rated collaterals.  The departure was again made when the NY Fed was granted authority to lend to Fannie Mae and Freddie Mac to supplement the Treasury’s moves to stabilize these government sponsored enterprises (GSEs). As it turned out, the Treasury had to place both GSEs under conservatorship in September 2008.
Nevertheless, a brave new world of central banking began with these new authorities by the Fed to make unconventional loans against toxic assets. Besides TARP programs, mortgage financiers Fannie Mae and Freddie Mac have received more than $125 billion in federal aid. There is no indication that either firm will be able to repay the government anytime soon, if ever.
In March, 2008, J. P. Morgan Chase had been provided with a $29 billion credit line from the Fed discount window in its purchase of Bear Stearns arranged by the Treasury. In early September, the Treasury seized control of two troubled government sponsored enterprises (GSE) Fannie Mae and Freddie Mac with a $200 billion capital injection against a $4.5 trillion liability, concurrent with another government arranged “shotgun marriage” that induced Bank of America to acquire Merrill Lynch at a fire sale price of $50 billion.
The Paulson Treasury had been criticized and had become sensitive to criticism of bailing out private Wall Street firms that should have been allowed to fail from irresponsible market misjudgments and Henry Paulson was eager to show that going forward it was not government policy to increase moral hazard. 
Lehman Bankruptcy
Lehman Brothers’ bankruptcy filing on September 15, 2008 was the result of failure of the coordinated efforts by the Bernanke Fed and the Paulson Treasury to find a qualified buyer for the failing firm. At the end, the refusal of the Bank of England to approve the participation of Barclay was a bridge too far in a desperate campaign to save Lehman. Secretary Paulson, sensitive to criticism of distorting markets for having bailed out Merrill Lynch, resisted pressure to bailout Lehman. Alan Meltzer, professor of political economy at Carnegie Mellon University and the respected author of A History of the Federal Reserve, argued that allowing Lehman to fail was “a major error that deepened and lengthen the current recession.”
Bernanke, while defending the Fed’s inaction by citing a technical legal restraint on Fed lending without adequate collateral, which Lehman did not have in relations to its funding needs, admitted on public television afterwards that “Lehman proved that you cannot let a large internationally active firm fail in the middle of a financial crisis.”
He might as well have added you also cannot bailout a large internationally active firm without long-term effects on market operations with penalties for the economy. By now, it is becoming clear that the difference between government bailouts and no-bailouts is not different levels of economic pain, but how the pain will be borne over time and by whom – those who were responsible for the crisis, or innocent taxpayers. Once those responsible for the crisis were allowed to escape with no penalty, no reform can prevent replays of the crisis.
Within hours of the Lehman bankruptcy filling, the Fed was confronted with the imminent failure of the American International Group (AIG) from exposure to thefailure of the subprime mortgage market through its underwriting of credit default swaps insurance and other derivative contracts and portfolio holdings of mortgage-backed securities. All concerns of moral hazard went out the window as the Bernanke Fed and the Paulson Treasury panicked and opened the door to save dysfunctional market capitalism by replacing it with state capitalism. The pain was relieved by putting the patient in a coma.
AIG Bailout
Determining that AIG was too big to fail, the Federal Reserve Board on September 16 announce that “in current circumstances, a disorderly failure of AIG could add to already significant levels of financial market fragility and lead to substantially higher borrowing costs, reduced household wealth and materially weaker economic performance,” to justify invoking Section 13(3) of the Federal Reserve Act to make an $85 billion loan to AIG, secured by the assets of AIG and its subsidiaries.
In the course of two days, The Fed took different approaches in dealing with imminent failure of two major institutions, both of which were not depository institutions and therefore not qualified for funding support through the Fed’s normal lending programs.
In Lehman, the Fed determined it did not have the legal authority to prevent its failure and also even if with legal authority, Lehman’s net asset was not inadequate collateral for its funding needs. The Fed then concentrated on limiting the impact on other financial firms and markets. The Fed was able to protect some large institutions that were counterparties to Lehman positions, but it did nothing to protect the general public around the world who invested in allegedly high rated Lehman bonds without the benefit of full disclosure.
In AIG, the Fed deemed a rescue necessary to protect the financial system and the economy enough to invoke Section 13(3).  The Fed has been widely criticized for not rescuing Lehman when efforts to find a buyer for it failed, allegedly resulting in a deepening and lengthening the consequent recession.  Yet the bailout of subsequent distressed firms did not prevent the recession.
Reserve Primary Fund Broke the Buck
The Lehman bankruptcy did produce immediate fallouts. On September 16, 2008, one day after the bankruptcy filing, a major money market fund, Reserve Primary Fund, with $62 billion under management, announced that the net asset value of its unit share has fallen below the required $1 level because of losses incurred o the fund’s holdings of Lehman commercial paper and medium term notes. Money market funds are supposed to be super safe. They can yield near zero returns but they are not supposed to lose principal.
The news of Reserve Primary Fund “breaking the buck” triggered widespread withdrawal from other money market funds, creating a system wide run on the money markets. This prompted the Treasury to announce a temporary program to guarantee investment in participating money market funds.
Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility
The Fed responded to the run of money market funds by again invoking Section 13(3) to establish the Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility (AMLF) to extend non-recourse loan to US depository institutions and bank-holding companies to finance purchases of asset-backed commercial paper from money market mutual funds. A non-recourse loan is ultimately guaranteed only by the collateral pledged for the loan and not other assets of the borrower.   
On September 21, 2008, the Fed approved the applications of Goldman Sachs and Morgan Stanley, both non-deposit-taking institutions, to become bank-holding companies and authorized the NY Fed to extend credit to the broke-dealer subsidiaries of both firms.
A few days later, the Fed increased its swap lines with the European Central Bank (ECB) and several other central banks around the world to supply additional dollar liquidity in the international market.
Commercial Paper Funding Facility (CPFF)
Yet, financial market turmoil continued in the ensuing weeks despite the massive bailout programs. To revive the stalled commercial paper market, the Fed invoked again Section 13(3) to introduce the Commercial Paper Funding Facility (CPFF) on October 7, 2008. This facility provided financing for a special-purpose vehicle established to purchase 3-month unsecured and asset-backed commercial paper directly from eligible issuers.
In recent decades, the commercial paper (CP) market has become an important part of the financial system as an alternative source to bank loans for lower-cost short-term financing. In recent years, the CP market has become dominated by financial issuers rather than industrial issuers. Large investors purchase CP directly while small investor purchase through money market mutual funds (MMMFs) which intermediate between large denomination CP and the liquid, small denomination share issued to retail investors. The CP market is now larger than the Treasury bills market.
Large companies, such as GE, can issue their unsecured CP directly through its finance subsidiary such as GE Capital, or via an agent or dealer known as a single-seller conduit. Small firms, to save cost, prefer to borrow through a multi-seller conduit in which a small firm sells its debt to a bank-advised special purpose vehicle (SPV) which in turn sells asset-backed commercial paper (ABCP) to many investors. The ABCP SPV purchases the debt, mostly collateralized debt obligations (CDO), at a discount from its face value to maintain an over-collateralization (a haircut to the seller of the debt) to provide an equity cushion for the investors. CDOs are securitized instruments which derive its cash flow from ongoing payments of consumer debt obligations, such as credit card obligation, car finance obligations or other installment payment obligations.
Because the maturity of the CP is shorter than the maturity on the underlying loan, the ABCP conduit will roll over the maturing CP to pay old investors with money from new investors. Liquidity providers will provide funds for a fee in case some CP is not rolled over. To assure investors, additional program-wide credit enhancement on the form of bank letter of credit at higher interest rate is arranged, but is only drawn upon if needed.  Dealers charge clients a fee that is less than one eighth of 1 percentage point, which in 2008 translated into roughly $150 million in daily fees on $120 billion new CP issued daily.
Asset-backed commercial paper (ABCP) and Special Purpose Vehicles (SPV)
Asset-backed commercial paper (ABCP) is CP with specific assets attached, issued as security by “conduits” that are structured to be bankruptcy remote and limited in purpose. Each conduit includes a “special purpose vehicle (SPV) that is the legal entity at the center of the program and a financial advisor (usually a commercial or investment bank) that manages the program and determines the assets to be purchased and the ABCP to be issued. The owner of the conduit receives nominal dividend payments. Since the SPV does not generally have any employees, fees are paid to an administrator (normally a bank) to manage CP rollovers and the flow of funds.
SPVs, especially the more complex ones, are opaque entities that hold assets undisclosed to the purchaser of their ABCP. For this lack of transparency, ABCP generally yield some 75basis point more than traditional unsecured CP. The market calculates the spread using rates on AA-rated CP reported in the Fed volume statistics on CP issuance. The spread changes depending on the issue type, financial or non-financial, and maturity chosen.
The spread is a mysterious outcome. Why should CP with specific attached assets as collateral pay a higher yield than CP with only general collateral? Moody’s attributed the yield premium to lack of transparency. As financial intermediaries, CP conduits purchased financial assets and issued ABCP under their own name, performing the task of risk and rate spread arbitrage between assets they purchased and the liabilities they issued. To insure against risk, the conduits bought credit default swaps (CDS) from a highly rated insurer such as AIG which collected profitable fee against defaults that were not expected to happen.
AIG Financial Products (AIGFP)
AIG Financial Products (AIGFP), based in London where the regulatory regime was less restrictive, took advantage of AIG statue categorization as an insurance company and therefore not subject to the same burdensome rules on capital reserves as banks imposed by the Fed or the FDIC. AIG would need to set aside only a tiny sliver of capital to insure the super-senior risk tranches of CDOs (collateralized debt obligations) in its holdings. Nor was AIG likely to face hard questions from its own regulators in New York because AIGFS had largely fallen through the interagency cracks of oversight. AIGFS operation in the US was regulated by the US Office for Thrift Supervision, whose staff had inadequate expertise in the field of cutting-edge structured finance products.
AIGFP insured bank-held super-senior risk CDOs in the broad CDS market. AIG would earn a relatively trifle fee for providing this coverage – just 0.02 cents for each dollar insured per year. For the buyer of such insurance, the cost is insignificant for the critical benefit, particularly in the financial advantage associated with a good credit rating, which the buyer receives not because the instruments are “safe” but only that the risk was insured by AIGFP. For AIG, with 0.02 cents multiplied a few hundred billion times, it adds up to an appreciable income stream, particularly if no reserves are required to cover the supposedly non-existent risk. Regulators were told by the banks that a way had been found to remove all credit risk from their CDO deals.
Credit Default Swaps (CDS)
The Office of the Comptroller of the Currency and the Federal Reserve jointly allowed banks with credit default swaps (CDS) insurance to keep super-senior risk assets on their books without adding capital because the risk was insured. Normally, if the banks held the super-senior risk on their books, they would need to post capital at 8% of the liability. But capital could be reduced to one-fifth the normal amount (20% of 8%, meaning $160 for every $10,000 of risk on the books) if banks could prove to the regulators that the risk of default on the super-senior portion of the deals was truly negligible, and if the securities being issued via a collateral debt obligation (CDO) structure carried a Triple-A credit rating from a “nationally recognized credit rating agency”, such as Standard and Poor’s rating on AIG.
With CDS insurance, banks then could cut the normal $800 million capital for every $10 billion of corporate loans on their books to just $160 million, meaning banks with CDS insurance can loan up to five times more on the same capital. The CDS-insured CDO deals could then bypass international banking rules on capital.  To correct this bypass was a key reason why the government wanted to conduct stress tests on banks in 2009 to see if banks needed to raise new capital in a Downward Loss Given Default. Moody’s defines loss given default as the sum of the discounted present values of the periodic interest shortfalls and principal losses experienced by a defaulted tranche. The coupon rate of the tranche is used as the discount rate.
CDS contracts are generally subject to mark-to-market accounting that introduces regular periodic income statements to show balance sheet volatility that would not be present in a regulated insurance contract. Further, the buyer of a CDS does not even need to own the underlying security or other form of credit exposure. In fact, the buyer does not even have to suffer an actual loss from the default event, only a virtual loss would suffice for collection of the insured notional amount.
So, at 0.02 cents to a dollar (1 to 10,000 odd), speculators could place bets to collect astronomical payouts in billions with affordable losses. A $10,000 bet on a CDS default could stand to win $100,000,000 within a year. That was exactly what many hedge funds did because they could recoup all their lost bets even if they only won once in 10,000 years. 
As it turns out, many only had to wait a couple of years before winning a huge windfall and driving AIG into insolvency in the process. But until AIG was bailed out by the Fed, these winning hedge funds were not sure they could collect their winnings. Lucky for the winning hedge funds, the Fed, by bailing out AIG, paid them in full. (Please see my June 24, 2009 AToL article: Greenspan Characterized Regulatory Arbitrage as Desirable)
Money Market Investor Funding Facility (MMIFF)
On October 7, 2008, Section 13(3) was also invoked by the Fed to create the Money Market Investor Funding Facility (MMIFF) under which the Fed offered to provide loans to series of special-purpose vehicles that purchased assets from money market mutual funds and other eligible investors. Special-purpose vehicles were the venue that the likes of Enron and Lehman used to hide liabilities from their balance sheets. (Please see my January 23, 2009 article: No Exit for Emergency Nationalization)
CitiGroup Bailout
Within a month, on November 23, 2008, Citigroup was the next too-big-to-fail institution requiring assistance from the government. The Fed participated with the Treasury and the FDIC in a financial assistance package to provide a non-recourse loan to support a government guarantee of $300 billion of real estate loans and securities held by Citigroup, although the Fed has yet to be called upon by Citigroup to make a loan under the agreement.
Term Asset-Backed Security Lending Facility (TALF)
Tow days later, on November 25, 2008, the Fed again invoke Section 13(3) to create the Term Asset-Backed Security Lending Facility (TALF) under which the NY Fed provided non-recourse loans to holders of Triple-A-rated asset-backed securities and recently originated consumer and small business loans. The TALF was launched on March 3, 2009. The types of eligible collateral were subsequently expanded on March 19 and May 19, 2009.
Throughout the fall of 2008, the Fed approved more large financial firms to become bank holding company, including American Express, CIT Group, and (General Motors Acceptance Corporation (GMAC) which has generated some 60% of General Motors revenue by financing car installment purchases and leases, but its main profit in pre-crisis years had been financing subprime mortgages. Despite government help, CIT Group eventually filed bankruptcy protection while GMAC had to be bailed out by the Treasury.
CIT Bankruptcy
CIT Group filed for Chapter 11 bankruptcy protection on November 1, 2009, in an effort to restructure its debt while trying to keep loans flowing to the thousands of mid-sized and small businesses.
CIT bankruptcy will wipe out current holders of its common and preferred stock, likely meaning the US government and taxpayers will lose the $2.3 billion sunk into CIT in 2008 to prop up the ailing company. Goldman Sachs however, will gain $1 billion because of CIT’s bankruptcy, according to a report published October 4 by the Financial Times:
The payment stems from the structure of a $3 billion rescue finance package that Goldman extended to CIT on June 6, 2008, about five months before the Treasury bought $2.3 billion in CIT preferred shares to prop it up at the height of the crisis...
While Goldman is entitled to demand the full amount, it is likely to agree to postpone payment on a part of that sum, these people added. A CIT filing last week said that it was in negotiations with Goldman "concerning an amendment to this facility".
The $2.3 billion lost in taxpayer funds is the largest amount lost since the government began infusing banks with capital, according to the Financial Times.
CIT made the filing in New York bankruptcy court on a Sunday, after a debt-exchange offer to bondholders failed. CIT said in a statement that its bondholders have overwhelmingly approved a prepackaged reorganization plan which will reduce total debt by $10 billion while allowing the company to continue to do business to provide funding to our small business and middle market customers, two sectors that remain vitally important to the US economy.
The CIT Chapter 11 bankruptcy filing is one of the biggest in recent US corporate history. Only Lehman Brothers, Washington Mutual, Worldcom and General Motors had more in assets when they filed for protection. CIT’s bankruptcy filing shows $71 billion in finance and leasing assets against total debt of $64.9 billion. Its collapse is the latest in a string of huge cases driven by the financial crisis over the past two years, as bailed-out industry heavyweights like General Motors and Chrysler both entered bankruptcy court.
CIT said all existing common and preferred stock will be cancelled upon emergence from bankruptcy protection. That would likely include preferred stock from the $2.3 billion in funding from the government’s Troubled Asset Relief Program (TARP) the company received in its efforts to stay afloat.
CIT sought a second federal bailout in July 2009 but the request was rejected. It was then able to get a $3 billion loan from bondholders in order to stave off bankruptcy temporarily.
CIT had been trying to fend off disaster for several months earlier and narrowly avoided collapse in July, 2009. It has struggled to find funding as sources it previously relied on, such as short-term debt from the repo market, evaporated during the credit crisis.
CIT had received $4.5 billion in credit from its own lenders and bondholders a week before filing for bankruptcy, reportedly made a deal with Goldman Sachs to lower debt payments, and negotiated a $1 billion line of credit from billionaire investor and bondholder Carl Icahn. But the company failed to convince bondholders to support a debt-exchange offer, a step that would have trimmed at least $5.7 billion from its debt burden and given CIT more time to pay off what it owed.
The bankruptcy filing was bad news for small businesses, many of which look to CIT for loans to cover expenses at a time when other credit is hard to come by. Already ailing sectors, such as consumer goods retailers, would be hit especially hard, since CIT served as the short-term financier for about 2,000 vendors that supply merchandise to more than 300,000 consumer retail stores.
Congressional Oversight Panel Criticized Fed Handling of GMAC
On March 10, 2010, the Congressional Oversight Panel (COP) under Elizabeth Warren released a new report: The Unique Treatment of GMAC Under the TARP which also criticizes the handling of GMAC under TALF.
The Term Asset-Backed Securities Loan Facility (TALF) is the name of a program created by the Fed November 25, 2008. It provided support to the market for asset-backed securities, such as those that are backed by auto loans, credit card loans, small business loans, and student loans. TALF was closed on March 31, 2010 for loans backed by all types of collateral except newly issued commercial mortgage-backed securities (CMBS) and scheduled for closure on June 30, 2010 for loans backed by newly issued CMBS.
The Panel said it remains unconvinced that bankruptcy was not a viable option in 2008. In connection with the Chrysler and GM bankruptcies, Treasury might have been able to orchestrate a strategic bankruptcy for GMAC. This bankruptcy could have preserved GMAC’s automotive lending functions while winding down its other, less significant operations, dealing with the ongoing liabilities of the mortgage lending operations, and putting the company on sounder economic footing.

The federal government has so far spent $17.2 billion to bail out GMAC and now owns 56.3 percent of the company. Both GMAC and Treasury insist that the company is solvent and will not require any additional bailout funds, but taxpayers already bear significant exposure to the company, and the Office of Management and Budget (OMB) currently estimates that $6.3 billion or more may never be repaid.
Although the Panel took no position on whether Treasury should have rescued GMAC, it found that Treasury missed opportunities to increase accountability and better protect taxpayers’ money. Treasury did not, for example, condition GMAC access to TARP money on the same sweeping changes that it required from GM and Chrysler: it did not wipe out GMAC’s equity holders; nor did it require GMAC to create a viable plan for returning to profitability; nor did it require a detailed, public explanation of how the company would use taxpayer funds to increase consumer lending. Moreover, the Panel remains unconvinced that bankruptcy was not a viable option in 2008.

In light of the scale of these potential losses, the COP report expressed deeply concern that Treasury has not required GMAC to lay out a clear path to viability or a strategy for fully repaying taxpayers. Moving forward, Treasury should clearly articulate its exit strategy from GMAC. More than a year has elapsed since the government first bailed out GMAC, and it is long past time for taxpayers to have a clear view of the road ahead.
And a few recommendations from COP:
• Treasury should insist that GMAC produce a viable business plan showing a path toward profitability and a resolution of the problems caused by ResCap.
• Treasury should formulate, and clearly articulate, a near-term exit strategy with respect to GMAC and articulate how that exit will or should be coordinated with exit from Treasury’s holdings in GM and Chrysler.
• To preserve market discipline and protect taxpayer interests, Treasury should go to greater lengths to explain its approach to the treatment of legacy shareholders, in conjunction with both initial and ongoing government assistance.
This fits with the earlier discussions on the stress tests since GMAC was on the “Stress Test 19”. It probably would have cost the taxpayers far less to have GMAC file bankruptcy than the current situation.
Government Takeover of Government Sponsored Enterprises
On September 7, 2008, Treasury officials unveiled an extraordinary takeover of government sponsored enterprises (GSEs): Fannie Mae and Freddie Mac, putting the government in charge of the twin mortgage giants and the $5 trillion in home loans the GSEs back.
The move, which extends as much as $200 billion in Treasury support to the two companies, marks the government’ most dramatic attempt yet to shore up the nation’s collapsed housing market to try to stop record foreclosures and falling prices. The sweeping plan, announced by Treasury Secretary Henry Paulson and James Lockhart, director of the Federal Housing Finance Agency, places the two government sponsored enterprises into a "conservatorship" to be overseen by the Federal Housing Finance Agency. Under conservatorship, the government would temporarily run Fannie and Freddie until they are on stronger footing.
Fannie (FNM) and Freddie (FRE), which were created by the U.S. government, have been badly hurt in the past year of the on-going crisis by the sharp decline in home prices as well as rising mortgage delinquencies and foreclosures. All told, the two firms have racked up about $12 billion in losses since the summer of 2007.
Dividends on both common and preferred shares of Fannie and Freddie will be eliminated in an effort to conserve about $2 billion annually. All lobbying and political activities by the GSEs will be halted immediately and charitable activities reviewed.
In addition, the Treasury Department announced a series of moves targeted at providing relief to both housing and financial markets. Paulson said Treasury would boost housing by purchasing mortgage-backed securities from Freddie and Fannie, as well as offering to lend money to the companies and the 12 Federal Home Loan Banks. The home loan banks advance funds to more than 8,000 member banks. The Treasury, with fellow regulator FHFA, will also buy preferred stock in Fannie and Freddie to provide security to the companies' debt holders and bolster housing finance. The government, in agreeing to backstop the firms, said it would receive $1 billion in each company's senior preferred stock. The government will also receive a quarterly dividend payment and the right to own 79.9% of each company.
Shares of Fannie and Freddie, which have fallen more than 80% since the beginning of the credit crisis, had been hammered in the summer of 2008 among concerns they would need to raise additional funds to cover future losses or need to be taken over by its federal regulator. Investors feared that either step would reduce or wipe out the value of current shareholders’ stakes.
In mid-July, 2008 the Treasury Department and Federal Reserve announced steps in to make funds available to the firms if necessary and Congress approved the sweeping proposals later that month.
Shortly thereafter, regulators stepped up their review of Fannie and Freddie. Secretary Paulson announced in August that he had tapped Wall Street firm Morgan Stanley to help him examine the firms.
Morgan Stanley had determined that both Freddie and Fannie faced "meaningful" capital issues before deciding that government intervention was necessary. Officials ruled out a capital infusion - a less drastic option than convervatorship - after considering questions such as whether the government would have to keep putting money in and how best Treasury officials could protect taxpayers. In the end, the route taken amounted to “a timeout, not a liquidation.” Conservatorship leaves all options open for the Obama administration.
Following an exhaustive review, FHFA’s Lockhart said that the two companies could not continue to operate without taking “significant action”. Fannie and Freddie had become virtually the only source of funding for banks and other home lenders looking to make home loans. Their ability to do so is crucial to the recovery of the battered home market and the broader U.S. economy.
The two firms buy loans, attach a guarantee, then sell securities backed by the loans' income stream. All told, they own or back $5.4 trillion worth of home debt - half the mortgage debt in the country.
The Treasury-FHFA plan, which was widely anticipated after financial markets closed on Friday, drew praise from regulators, lawmakers and some market experts.
President Bush called the move “critical” to the housing market recovery. “Americans should be confident that the actions taken today will strengthen our ability to weather the housing correction and are critical to returning the economy to stronger sustained growth in the future,” he said.
Fed Chairman Ben Bernanke, who along with Paulson has led efforts to help get the US housing market and the broader economy back on track, endorsed the move by Lockhart and Paulson. “These necessary steps will help to strengthen the US housing market and promote stability in our financial markets,” Bernanke said in a statement.
Senator Charles Schumer, D-N.Y., a member of the Senate Banking Committee, said that Paulson had “threaded the needle just right” with the plan, noting that it will likely be met with praise from other lawmakers.
Pimco’s Bill Gross, a widely followed bond fund manager, said that the Freddie-Fannie plan was the right move. “This is a significant step and almost exactly what we had hoped for,” Gross told
In addition to confirming the government's sovereign credit rating, Standard & Poor’s affirmed its sterling AAA rating on both Fannie Freddie on the news, adding that its outlook for the two firms to be stable.
At first blush, Wall Street seemed encouraged by the news, although the true test came when financial markets around the globe failed to rally. The cost of the government intervention remained unclear however. Experts argue that it will depend in large part on the structure of the rescue, the direction of home prices and mortgage default rates.
Still it seems almost certain it will run into the billions and will most likely eclipse such other high-profile government bailouts including than the Fed’s $29 billion backing of Bear Stearns assets when it was taken over by J.P. Morgan Chase.
Paulson said that the cost to taxpayers would largely depend on the future financial performance of Fannie and Freddie. But he stopped short of saying that the future appeared rosy. The problem would be handed over to his Democrat successor, Timothy F. Geithner.
Another unintended yet unavoidable consequence may be the adverse impact on the nation’s troubled banks. Some of the nation's largest financial institutions including JPMorgan Chase and Sovereign Bancorp own a big chunk of the estimated $36 billion in preferred shares of Fannie and Freddie. Those stakes are at risk of being wiped out.
Top banking regulators, including the Federal Reserve as well as the FDIC, said in a joint statement that a limited number of smaller institutions have significant preferred share holdings in Fannie and Freddie. They added they are prepared to work with these institutions to come up with a plan should they need to raise capital.
The government rescue of Fannie and Freddie has so far fall short of its intended aim - bringing stability to the housing market while making it easier for consumers to obtain affordable mortgages. Foreclosure rate has not dropped and home sale has remained stagnant.
The Issue of Interest Rates
After the market closed on Thursday, February 16, 2010, the Fed raised the discount rate, at which banks are charged when they borrow from the Fed, by 25 basis points to 0.75%, making it 50 to 100 basis points higher than the Fed Funds rate at 0 to 0.25% set 14 months ago on December 15, 2008.
The Fed took pain to draw attention to the distinction between the discount rate and its target for overnight interbank rates, called the Fed Funds rate, its main monetary policy tool. The Fed Funds rate target remains unchanged near zero percent, while a still fragile US economy strains in vain to gain recovery traction to lowering unemployment and to increasing consumer demand. The Fed appears powerless in getting banks, which are receiving practically free loans form the Fed, to lend into the market, particularly to small and medium businesses through which most new jobs are expected to be created.
The Fed statement read: “Like the closure of a number of extraordinary credit programs earlier this month, these changes [of the discount rate] are intended as a further normalization of the Federal Reserve’s lending facilities. The modifications are not expected to lead to tighter financial conditions for households and businesses and do not signal any change in the outlook for the economy or for monetary policy.”
What the Fed statement conveniently left out was that the higher discount rate is also not expected to ease still tight financial conditions for household and businesses.  In other words, raising the discount rate is largely an empty gesture to impress the market that the Fed has not forgotten the need to protect the exchange value and purchasing power of the dollar. Yet, historical data suggest that a return to normalcy of Fed lending facilities can only mean a return to the decades of monetary excess represented by the free money regime of the past two years.
The discount rate is the interest rate charged to commercial banks and other depository institutions on loans they receive from their regional Federal Reserve Bank’s lending facility--the discount window. The Federal Reserve Banks offer three discount window programs to depository institutions: primary credit, secondary credit, and seasonal credit, each with its own interest rate. All discount window loans are fully secured.
Under the primary credit discount program, loans are extended for a very short term (usually overnight) to depository institutions in generally sound financial condition. Depository institutions that are not eligible for primary credit may apply for secondary credit to meet short-term liquidity needs or to resolve severe financial difficulties. Seasonal credit is extended to relatively small depository institutions that have recurring intra-year fluctuations in funding needs, such as banks in agricultural or seasonal resort communities.
The discount rate charged for primary credit (the primary credit rate) is set sometimes above and sometimes below the level of short-term market interest rates, depending on the Fed judgment on market conditions. Because primary credit is the Federal Reserve’s main discount window program, the Federal Reserve at times uses the term “discount rate” to mean the primary credit rate. The discount rate on secondary credit is generally above the rate on primary credit. The discount rate for seasonal credit is an average of selected market rates.
The term “discount rate”, although widely used, is actually an anachronism. Since 1971, Reserve Bank loans to depository institutions have been secured by advances. Interest is computed on an accrual basis and paid to the Fed at the time of loan repayment.  The discount rate is important for two reasons: (1) it affects the cost of reserves borrowed from the Federal Reserve and (2) changes in the rate can be interpreted as an indicator of monetary policy.  Increases in the discount rate generally reflect the Federal Reserve’s concern over inflationary pressures, while decreases often reflect a concern over economic weakness or in recent times, deflation.
Discount-window lending, open market operations to effect changes in reserves to set Fed funds rates, and bank reserve requirements are the three main monetary policy tools of the Federal Reserve System. Together, they influence the cost and supply of money and credit, a major component in macroeconomics.
Normally, the discount rate is set lower than the Federal Funds and other money-market interest rates. However, the Fed does not allow banks to borrow at the discount window for profit. Thus, it monitors discount-window and Federal Funds activity to make sure that banks are not borrowing from the Fed in order to lend at a higher rate in the Federal Funds market.
During periods of monetary ease, the spread between the Federal Funds and discount rates may narrow or even disappear briefly because depository institutions have less of a need to borrow reserves in the money market. Under these conditions, the Fed may adjust the discount rate in order to reestablish the accustomed spread. 
Discount window loans are granted only after Reserve Banks are convinced that borrowers have fully used reasonably available alternative sources of funds, such as the Federal Funds market and loans from correspondents and other institutional sources. The latter sources include the credit programs that the Federal Home Loan Banks and the Central Liquidity Facility of the National Credit Union Administration provide for their members.
Usually, relatively few depository institutions borrow at the discount window in any one week. Consequently, such lending provides only a small fraction of the banking system’s total reserves. All depository institutions that maintain reservable transaction accounts or
nonpersonal time deposits are entitled to borrow at the discount window. This includes commercial banks, thrift institutions, and United States branches and agencies of foreign banks. Prior to the passage of the Depository Institutions Deregulation and Monetary Control Act of 1980, discount window borrowing generally had been restricted to commercial banks that were members of the Federal Reserve System. In the course of the current financial crisis, the Fed has allowed financial firms, such as Goldman Sachs, to declare themselves as bank holding companies to qualify as borrowers at the Fed discount window.
Changes in the discount rate generally have been infrequent. In the decades from 1980 through 1990, for example, there were 29 discount rate changes, and the duration of the periods between adjustments ranged from two weeks to 22 months. However, following those 22 months without a change, the Fed cut the discount rate seven times in the period of economic sluggishness from December 1990 to July 1992 -- from 7.0 percent at the start of the period to 3.0 percent at the end. From May 1994 to February 1995, when the Fed was concerned about the threat of inflation, it raised the discount rate four times -- from 3.0 to 5.25 percent.
Changes in the discount rate often lag changes in market rates. Thus, even though the Fed pushed the Federal Funds rate down 25 basis points in July 1995, as of December that same year it had not cut the discount rate. Since 1980, the changes in the discount rate have been by either 50 or 100 basis points (one half or a full percentage point), although mostly quarter-point changes were made in earlier years. This reflects the insensitivity of the money market to discount rate levels. The lowest discount rate charged by the New York Fed was 0.5%, which was in effect from 1942 through 1946; the highest rate was 14%, which lasted from May to November 1981 when the Fed Funds rate was at 20%.
Starting in mid July 1971, the discount rate had been set below the Fed Funds rate, with a spread of 300 basis points on August 13, 1973 at 7.5% against a Fed Funds rate at 10.5%. On February 4, 1975, the Fed reversed the pattern to set the discount rate at 6.75%, 50 basis points above the Fed Funds rate target at 6.5%. Generally, when the discount rate is set above the Fed Funds rate target, the Fed is punishing banks that borrow from the discount level, with the aim of slowing the supply of high power money from the Fed.
On August 29, 1977, the Fed again reversed the pattern to set the discount rate at 5.75%, 25 basis points below the Fed Funds rate at 6%. The pattern was reversed again on May 28, 1980 with the discount rate set at 12%, 225 basis points above the Fed Funds rate at 9.75%, until September 25 in the same year when the discount rate was set at 11%, 100 basis point below the Fed Funds rate at 12%.  Since January 25, 2003, when the Federal Reserve System implemented a “penalty” discount rate policy, the discount rate has been about 1 percentage point, or 100 basis points, above the effective (market) Fed Funds rate.
This history showed the high volatility of the money supply and the unusual swing of the Fed’s intervention in market interest rates. This was a departure form the Fed’s traditional preference for gradualism in interest rate fluctuation. It told the market that the Fed was repeatedly over-compensating its earlier overcompensation to produce damagingly high volatility in the money supply.
Discount rates are established by each of the six Reserve Bank’s board of directors, subject to the review and determination of the Board of Governors of the Federal Reserve System. The discount rates for the three lending programs are the same across all Reserve Banks except on days around a change in the rate. The discount rate is not set by the Fed Open Market Committee (FOMC) which has the authority to set the Fed Funds rate target to be implemented exclusively by the New York Fed through buying and selling treasury instruments in the repo market. The other eleven regional Reserve Banks do not participate in open market operations.
The Fed does not set interest rates directly. The FOMC sets targets and the Federal Reserve Bank of New York estimate money supply targets needed to hit those goals by participating in the repo market. (Please see my September 25, 2005 AToL article: The Repo Time Bomb and December 5, 2009 article: Repo Time Bomb Redux). The repo market has been a major source of short-term funds for financing long-term investments. In recent years, it has also become the legal channel to masking institution risk exposure by moving liabilities off balance sheet to categorizing the repo transactions as sales rather than collateralized loans.
The Federal Reserve is unlikely to make any big changes to its monetary policy stance in the near-term future, though there is a chance it could make some alterations to its provision of liquidity. The Fed is likely to keep the key line of its policy guidance – in which it says it expects to keep rates at “exceptionally low levels” for an “extended period” – unchanged.
However, the Fed expectedly announced a decision to increase the discount rate at which the Fed makes emergency loans to banks, coupled with reaffirmation from the Federal Reserve Board that it would shut down many emergency liquidity programs on February 1, 2010. This move would tighten financial conditions slightly at the margin, but it should not be mistaken for a tightening of monetary policy.
As the crisis ebbs, the Fed is borrowing a page from the European Central Bank, which draws a sharp distinction between monetary policy and liquidity policy, through a so-called “separation principle”. The Fed viewed this distinction as problematic mid-crisis but now it appears to believe it has relevance to the exit process. With financial markets once again buoyant but the economy still burdened with high unemployment, normalizing monetary policy and liquidity policy can be expected to proceed at differing pace.
The approach of the unified end of the financial year caused the Fed to defer action on liquidity into 2010, which will be the first time the former investment banks that became banking holding companies and the regular deposit-taking banks share the same December 31 year-end, making it impossible for them to shift illiquid assets back and forth to show strong year-end positions. Against that accounting convergence, there are more than $1 trillion excess reserves in the system to smooth over year-end liquidity stress.
The Fed amended its key guidance on the outlook for interest rates for the first time since March 2009. It added that the conditions on which this guidance – commonly understood to mean rates near zero for at least the next six months – is based. Implicitly in doing so it indicated what might lead to rate hikes within the six-month period.
Rather than change this template, the Fed is likely to update its discussion of the economy in ways that refer to the conditions. For instance, it may state that levels of resource utilization have improved slightly with the November 2009 employment report, although they remain low. Fourth-quarter 2009 growth was 5.7 per cent. However, the Fed will probably retain its assessment that inflation is moderate and inflation expectations stable.
Fed hawks and doves had been resting on a quiet truce in 2009 while positioning themselves for a fight in mid-2010. With unemployment still at 10%, and Congress turning hostile towards the Fed, the interest rate hawks are putting on their deficit hawk masks.  Yet excess capacity does not automatically translate into lowering of prices, as firms are forced to raise prices for price-insensitive customers to offset loss of revenue from price-sensitive customers. The result is stagflation.
The risk factors that could force an earlier battle on interest rates between hawks and doves have remained subdue. The dollar’s exchange rate has improved from sovereign debt crisis in the EU and commodity prices have stabilized for slow demand. Many policymakers are paying attention to asset prices and some are uneasy that interest rate guidance is feeding speculative trades. But there is a widespread preference for using regulatory tools rather than interest rates in the first instance to curb any emerging speculative excesses.
Going forward, the Fed’s extraordinary Section 13(3) Programs will pose a formidable challenge to the Fed’s exit strategy. The economy may have to limp along with government help for a whole decade.

April 18, 2010
Next: Public Debt, Fiscal Deficit and Sovereign Insolvency