Preventing a financial crash

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By Thomas

With the collapse of Bear Stearns, financial markets are moving closer to a crash that risks grave harm to the economy and the lives of working people. The Federal Reserve's recently created Term Auction Facility (TAF) and Term Securities Lending Facility (TSLF) move policy in the right direction. However, more needs to be done if a crash is to be prevented.

One way of thinking about Fed policy is in terms of the institutions the Fed deals with, the assets the Fed deals in, and the collateral the Fed accepts. The TAF and TSLF both expand the Fed's transactions menu, but the Fed has resisted expanding the set of institutions it deals with. Thus, initially only depository institutions were given access to the TAF, and only primary government securities dealers have access to the TSLF.

That is not adequate. Had Bear Stearns had access to the TAF its collapse might have been avoided. Now, the Fed has decided to give liquidity access to securities dealers like Bear Stearns, which is welcome but still belated.

The Fed's failure to expand the set of institutions it deals with reflects failure to adapt to the new world of financial intermediation. Previously, lending was dominated by banks, which meant the Fed could address liquidity shortages threatening the supply of credit by providing liquidity directly to banks. Today, lending is increasingly separated from banks. First, banks sell many of the loans they originate so that the ultimate lender is not a bank. Second, many originating lenders are non-bank firms. That means the credit supply is vulnerable to disruptions among these other lenders.

The current problem is that asset prices are falling owing to lack of confidence, triggering margin calls on these non-bank lenders. That has compelled them to sell assets, further driving down prices and triggering further calls. Some lenders have been unable to meet these calls, threatening bankruptcy even though their underlying loans are still performing. That threatens a cascade of asset price collapse.

The Fed's new facilities are a good move that broadens capacity to protect against liquidity disruptions. However, the Fed should further widen the set of institutions it deals with. Limiting dealings to depository institutions and primary government securities dealers protects banks and Wall Street's major brokerage houses, but leaves too much of the system unprotected and creates inefficiencies.

Firms outside the Fed's ring of protection must set up complex transactions with firms inside the ring to access emergency liquidity. That is good for insiders' fee income, but it raises the cost of distributing liquidity and creates unnecessary transactions that can be disrupted. Meanwhile, restricting access to the Fed's liquidity auction facility fails to discover the true price of liquidity that would be paid if all had auction access, which is tantamount to not getting liquidity to those who need it most. That is inefficient, and it also provides a subsidy to institutions inside the ring of protection.

In addition to expanding the institutions the Fed deals with, the Fed should consider further judicious expansion of the categories of securities it accepts as collateral under its auction (TAF) and securities lending (TSLF) facilities. Any additional collateral categories should be assessed at deeply discounted values as they will be more risky. That will protect taxpayers from bearing losses if the collateral under-performs.

Even equities could potentially be accepted, but this would involve crossing a bright line as they are a different form of legal obligation. By accepting equity collateral, the Fed could acquire an ownership stake in firms, which would move it beyond its current role of setting interest rates and providing liquidity to the financial system.

Among economic commentators there has been much misleading chatter about limits imposed by the size of the Fed's balance sheet. The reality is the Fed has no practical limit to its balance sheet as it can always directly purchase financial assets. There is no need for that now, but in the meantime the Fed might further increase the size of its auction facility and should definitely widen the set of auction participants.

Critics will inevitably claim such changes are inflationary. That has been the history of every innovation in central banking. However, the reality is innovations are only inflationary if used in an inflationary way. With regard to the current crisis, that means the Fed will have to withdraw liquidity convincingly once the crisis has abated.

Finally, stopping a financial crash does not get the US economy out of the woods. There remains the underlying residential mortgage debt crisis, and many risky mortgages will go bad as will the mortgage backed securities in which they are embedded. There is also the problem of recession, which calls for reviving aggregate demand and getting the economy growing again. Both the mortgage debt crisis and the recession need their own tailored policy responses. However, if the Fed fails to prevent a crash, the mortgage crisis will be deeper and a recession far more severe.