How Old Federal Reserve Laws Help Us In New Crises

An Old Law for a New Step at the Fed
by Sudeep Reddy
July 14, 2008 @ 12:24 am

The latest turn in the Federal Reserve’s efforts to prevent a deeper economic crisis came with its vote Sunday to authorize direct lending to Fannie Mae and Freddie Mac.

The central bank invoked powers established by Congress during the Great Depression to lend to individuals and companies, using a different piece of the law from March when the Fed started lending to investment banks.

The Fed’s existing authority effectively allowed it to stand behind the Treasury Department, whose much broader plan would require congressional approval, as a backstop for the two firms underpinning much of the U.S. housing market.

The Fed’s Board of Governors in Washington voted unanimously to allow the Federal Reserve Bank of New York to lend to Fannie Mae and Freddie Mac “should such lending prove necessary.”

The mortgage firms would borrow at the primary credit rate, which is now at 2.25%. That’s the same rate that commercial banks and securities firms pay for discount window access.

Before the credit crisis started last August, the Fed had maintained the discount rate at a full percentage point above the benchmark federal funds rate, the rate for overnight lending between banks that now stands at 2%.

The Federal Reserve Act’s Section 13(13), created in 1933 and amended in the late 1960s, allows the Fed to lend to any individual, partnership or corporation with collateral backed by U.S. government securities or securities issued by federal agencies. Fannie Mae and Freddie Mac debt is generally included in that latter category of safe holdings, even though it’s not directly guaranteed by the U.S. government.

In March, the Fed used Section 13(3) of the act to extend its lending arm to investment banks during the Bear Stearns liquidity crisis (first with an initial Bear Stearns loan and two days later in creating the primary dealer credit facility).

That provision allowed the Fed to lend during “unusual and exigent circumstances” only if a firm can’t borrow elsewhere.

The latest Fed action Sunday requires neither finding. The collateral allowed for investment banks was much broader, while the Fannie and Freddie lending would be safer from the Fed’s perspective because their holdings are more liquid and don’t require the same safeguards.

Lending under the 13(13) provision has occurred at various times from the 1930s through at least the early 1970s. Regular lending to investment banks has been in the tens of billions of dollars in some recent months (though it dropped to zero in the latest reporting period).

The lending to Fannie and Freddie could end up being zero, unless there’s a severe crisis in the markets. The Fed structured the latest arrangement to serve as a backstop: The mortgage giants would have to request to the New York Fed that they need the loan, but only after tapping their Treasury credit lines, which now stand at $2.25 billion even without the increases to be sought by the Treasury Department.

The government’s move Sunday to stand behind the two firms could offer enough support to prevent the kind of short-term liquidity fears that have hit investment banks, even though capital — not liquidity — had been the concern at Fannie and Freddie into the weekend.

The Fed did not provide an explicit timeline for how long the lending would be available. But the central bank said in its statement Sunday that it was acting to support Fannie Mae and Freddie Mac “during a period of stress in financial markets.”

For investment banks, the Fed has already indicated that the “unusual and exigent circumstances” may last into next year.

Debate is already underway about whether the existing Fed authority is adequate. Testifying about financial regulation before a House committee last week, Fed Chairman Ben Bernanke was asked whether the authority it used during the Bear Stearns crisis — under Section 13(3) — needed to be clarified to allow the Fed to act in the future. Mr. Bernanke replied:

“That was set up by Congress with the intention of creating a very flexible instrument that could be used in a variety of situations, and it allowed us to address the situation, which we did not anticipate, which we’ve not seen before. And so in that respect, having that flexibility I think was very valuable.”

Mr. Bernanke added, however, that in the short term “it’d be entirely appropriate” to have discussions with congressional leadership — as he did over the Bear Stearns weekend — “about what the will of the Congress and how we should be approaching these types of situations.”

He reiterated the call that he and Treasury Secretary Henry Paulson have made to create “a more formal mechanism that created some hurdles for decision-making, that set a high bar in terms of when these kinds of powers would be invoked, and provided more than just lending tools.

"It’s really not well suited in some cases to address systemically important failures.”

Unlike most aspects of the Treasury Department’s plan, the Fed won’t necessarily need congressional approval to get started on its new tasks.

The direct-lending, if it were even necessary, would be done under its existing authority. Treasury’s Mr. Paulson included the Fed as one piece of his three-part proposal to address the crisis, giving the central bank “a consultative role” in setting capital requirements and other standards with the new regulator for the government-sponsored mortgage giants.

The Fed already consults with other agencies that monitor financial institutions; earlier this month it signed an agreement with the Securities and Exchange Commission to cooperate in oversight of investment banks.

The balance sheets for the mortgage firms is less complex than for investment banks. As a result, the Fed conceivably could work more closely with the current regulator over Fannie and Freddie — the Office of Federal Housing Enterprise Oversight — even before any changes move through Congress.

How the latest decisions are intended to work in practice could become clearer in the coming days.

The weekend’s actions come just before Mr. Bernanke makes his semiannual monetary policy reports to Congress. He’ll face questioning from Senate lawmakers on Tuesday, followed by House members on Wednesday.

Article re-printed from Real Time Economics: http://blogs.wsj.com/economics