I would like to examine in some detail a recent report by Bloomberg about the actions of the Federal Reserve Bank during the depths of the 2008 financial crisis. Bloomberg, through a FOIA request, gained access to the records of the various facilities that the Federal Reserve created to inject liquidity into the banking system during the darkest hour of the financial crisis. At the time, the Fed disclosed the program in aggregate but did not identify specifically which firms were lent how much for how long. They argued that this was to avoid a stigma among the banks who might otherwise delay seeking liquidity for too long and thereby turn a liquidity problem into a solvency problem. For filing the request I think that Bloomberg should be congratulated because it sheds quite a bit of light on just how deep the freeze in short term lending markets became not merely among the banks but among corporates as well.
That said, the recent Bloomberg piece on the program which has stirred much controversy is a rather shoddy piece of sensationalist journalism designed to inflame rather than to inform. The over-arching narrative of the article, which came out on November 27th is that the Federal reserve liquidity facilities totaled $7.7 trillion dwarfing the Congressionally approved $700 billion TARP. The article asserts that, unlike the TARP, these funds were lent “with no strings attached” and that the fact that their recipients were not individually disclosed obscured just how serious the financial crisis was and therefore have hobbled the efforts of the legislature to reform the financial regulatory system as evidenced by the defeat of a bill to break up the top six banks or to reinstate Glass-Steagall.
The first things which draws the eye is the $7.7 trillion figure. They don't actually give too much detail as to what this comprises other than to say its what you get if you “add up guarantees and lending limits.” This number is highly suspicious because the total balance sheet of the Fed today, after two rounds of quantitative easing, stands at $2.8 trillion. How is it possible for the Fed to have lent a sum almost three times the size of its current balance sheet almost a trillion dollars larger than it was at the time? Well, it's not.What they are doing is counting all the loans made regardless of term which VASTLY overstates the extent of the amount of money at risk.
Here's how it works: let's say I lend you a million dollars over night and you pay me back the next day. Let's say we do this every day for 260 business days over the course of a year. Have I lent you $260 million over the course of a year? Yes. Was it ever possible for me to lose $260 million? No. the most I could lose was $1 million on any given day since if you don't pay me back you don't exist the next day for me to lend you another million. So to count all the loans over the entire time period in a single statement is to greatly inflate the sums involved. Which, of course, is precisely the objective of the Bloomberg article because it gets attention and with it clicks and reposts which you can see if you google “Federal Reserve $7.7 Trillion.”
That's the most egregious thing in the article and I almost forgive them because the click-based economics of internet journalism almost demand some kind of preposterous claim to encourage and diffusion of the article through social media. They do stick with that convention throughout the article which is unfortunate but they often refer to the days of maximum borrowing which give a better insight into the actual scale involved. What they don't do is provide any context as to what the relative importance of the Fed loans was to the overall capital structure of the firms nor do they compare the relative importance of the TARP and the Fed programs in order to support their claim that had the Congress known about the Fed program that much of the regulatory effort would be different. Luckily this perspective is actually pretty easy to come by, all that is required is a quick look at one of the larger recipients of both the Fed programs and the TARP. So let's have a look at JP Morgan. According to the documents that Bloomberg has acquired JP Morgan's borrowing peaked on February 28th 2009 at $45 billion. $45 billion? Whoa, sounds like a lot. They even point out in that this was larger than the cash holdings of JP Morgan. OK, let's have a closer look at the balance sheet from that era via the JPM 10-Q, here it is for your reading pleasure:
OK, sure enough the cash holdings of JPM were $26 billion, less than the amount of the Fed loans. The Fed loans would be in the section under “Liabilities” entitled “Other Borrowings” which totals $112 billion. Wait a minute, it seems from the Bloomberg article that JPM was entirely dependent on the Fed for its borrowings, in fact the Fed was less than half of the short term loans that JPM was funding with at the time. Actually the more you look, the less important the Fed loans are. The balance sheet as a whole is $2,079 billion, so the Fed is meeting around 2% of the funding needs of JPM not a huge number but let's think about what would have happened had the Fed withdrawn its support. Well, given that the cash position of JPM was $26 billion, they could have self funded that bit and then come up with an additional $19 billion which they could have done by converting $19 billion of their $90 billion in deposits at other banks to cash. So it would not have been fatal to JPM after all.
So if it wouldn't have been fatal to the bank then why do it at all? Well the answer to that is also seen on the balance sheet, as is the need for secrecy. Notice what happened from December 2008 to March of 2009, the balance sheet shrank by about $100 billion in total, as you can see total deposits shrank by the same amount. In essence there was a general level of fear in the economy that was leading people to pull their money out of the banks. JPM could have done without the Fed's support but to do so it would have had to withdraw $10 billion or so from other banks, and those banks in turn would have had to withdraw their money from other banks as well. This is what the Fed was trying to prevent, a generalized withdrawal of liquidity from the banking system which would have halted lending altogether and withdrawn a lot of liquidity from the general economy as banks shrank their balance sheets.
The Fed was able to stabilize the banking system with relatively small amounts of capital relative to the balance sheets precisely because of the policy of secrecy of the program. It was entirely possible that if they had disclosed at the time that this or that bank was borrowing from the Feds liquidity facilities that already spooked depositors would accelerate their withdrawals and thus force the banks to withdraw more money from one another or else further shrink their balance sheets. It would have been possible for the Fed to grow the program in that event but the fact that no one knew which bank was borrowing how much when meant that it wasn't possible to panic about any individual bank though there remained a fair amount of fear in the system as a whole.
So the liquidity program of the Fed was very helpful in supporting the banking system as a whole but it was not vital to any individual bank. It might have become a more acute issue if the Fed at the time had not maintained the veil of secrecy around it. The relatively mild nature of the program despite its secrecy is one reason why I do not think that more general knowledge of it would have affected Congressional regulatory actions after the crisis. The other is that while the Federal Reserve liquidity facilities were helpful to the banking system as a whole, the truly decisive government program was the Congressionally funded and overseen TARP program without which it is far more likely that the banking system would have collapsed entirely.
When thinking about the relative importance of the Fed's facilities and the TARP is the nature of the problems they were designed to solve. The Fed was primarily concerned with liquidity, the TARP with solvency and solvency was BY FAR the more serious problem. Liquidity is a question of at what cost must the firm get the funds it needs to operate day to day. Solvency is a question of whether the assets on the balance sheet are worth more or less than the sum of the liabilities plus the equity and thus whether the firm in fact exists. At the time Congress was aware of the what if not the who of the efforts on the liquidity front but it had a front row seat for the efforts on the solvency front.
When discussing this it is important to remember what happened during the Lehman bankruptcy. The Friday night before the collapse Tim Geithner called the heads of the big New York banks and investment firms to a meeting and ordered them to come up with a private sector rescue for Lehman Brothers. This was by no means even remotely possible, which Geithner should have known, because at the time the markets for securitized mortgages, the most problematic items on the Lehman balance sheet, had ceased to function whatsoever and the securities which comprised it were so complex that it was not possible even to model them with any degree of certainty. Therefore any would be rescuer would have to take a leap into the abyss and given the fact that the Lehman balance sheet was $600 billion, it was well beyond the capacity of the other banks in the room to saddle their own shareholders with the potential losses.
Those fears proved extremely well founded. After the collapse of Lehman there was an auction to determine the settlement price for CDS on Lehman Brothers which resulted in valuing the recovery rate, that is what unsecured creditors of Lehman could expect, at 9 cents on the dollar meaning the size of the balance sheet hole was gargantuan (and incidentally if the banks had obeyed Geithner he would have destroyed the entire system.) The knowledge of how deep that hole was sent waves of panic through the markets are called into question the balance sheets of every bank which also engaged in mortgage securitization, which was all of them. This is important because if it were the case that the assets of the remaining banks were worth less than the liabilities and the equity the banks would be insolvent. Fear of this led people to being withdrawing their funds from banks exacerbating the liquidity crisis. It was entirely possible for that liquidity crisis to develop into a solvency crisis by its own momentum which is why Congress enacted the TARP.
The TARP injected $250 billion onto the balance sheets of the banking system at the preferred stock level thereby adding an essential additional layer to the capital structure of the firm. Equity is the key element in this because the firm is solvent as long as the uncertainty around the balance sheet is less than the equity because it means all the unsecured lenders will recover all their funds in the event of a liquidation. This is why the TARP was structured in the way that it was and why it was crucial for the survival of the system as a whole, far more so than the Fed programs. At the time of the peak borrowing from the Fed the common stock of JPM was worth about $65 billion and the firm had $35 billion of preferred stock including $25 billion of TARP funds. So while the Fed was providing about 2.5% of the borrowings of JPM the taxpayer was providing 25% of the equity. So for Bloomberg to claim that the decisive aspect of the bailouts was the Fed liquidity facility is to do violence to the facts.
The Fed programs have largely been unwound and resulted in no losses to the Fed. The TARP still has billions outstanding and will result in losses to the taxpayers of about $30 billion. So of the two programs, by far the more crucial and the more painful for the taxpayers was the TARP rather than the Feds liquidity programs. Thus it is quite disingenuous for Bloomberg to claim that had there been more knowledge of the specific borrowers from the Fed that there would have been more effective regulation of the banking system in the Dodd-Frank Act. It is quite true that there are serious flaws in the Dodd-Frank Act and there has been a very effective campaign against implementation of some of the more useful features but to claim that this is because of a lack of knowledge of the Fed program is to provide a smoke screen for the real issues behind the failures of Dodd-Frank and to let Congress off the hook.