The Fed's Three Surprising Fixes

March 17, 2008 — -- The Federal Reserve made several surprising and unprecedented moves Sunday evening that, in the words of Federal Reserve chairman Ben Bernanke, are meant to ensure "well-functioning markets."

The Federal Reserve lowered an interest rate and it allowed investment banks to get loans from the Federal Reserve. Those moves came as the Fed helped JP Morgan Chase take over Bear Stearns by assuming the troubled bank's $30 billion portfolio.

At the request of the Federal Reserve Bank of New York, the Federal Reserve Board unanimously voted to lower the "discount rate" from 3.50 percent to 3.25 percent.

This is the interest rate charged to depository institutions like banks for loans in return for collateral that the bank provides to the Fed. In the past, these were overnight loans, but in September, the loans were extended to 30 days.

On Sunday, the Fed not only lowered the interest rate, it extended the loan period to 90 days.

But by far the most significant action taken by the Fed was to open the discount window to what are called primary dealers, institutions that are not traditional banks. This category includes investment banks like Goldman Sachs and Morgan Stanley, and if it was still around, Bear Stearns.

These investment banks can now go directly to the Fed, offer up a broad range of collateral -- much broader than previously accepted -- and get an overnight loan for 3.25 percent.

The collateral accepted by the Fed can be any investment grade security. That means it could take on those mortgage loans that no one else wants.

This special facility for the primary dealers -- the Primary Dealer Credit Facility -- starts today and will last at least six months.

The Fed says it will make loans based on the current value of whatever is being offered as collateral and that it will impose an even lower price in order to get a loan, referred to as a "haircut."

Why would it do this?

First, to get the money flowing again. Financial institutions and officials are so worried and fearful that the money for credit, for loans and for deals has dried up. By taking the collateral, the Fed is trying to get jammed-up financial gears going again by pouring some fresh liquid onto them in the form of U.S. treasuries and money.

Second, by creating this new lending facility, the Fed will not have to do again what it did Friday in order to save a company like Bear Stearns from crashing.

On Friday, the Fed provided funding to Bear Stearns through JP Morgan Chase. By creating this new way for investment banks like Bear Stearns to get needed cash, the Fed will now not have to react with ad-hoc programs to prevent a bank from going belly up.

The Fed felt it was important that the JP Morgan-Bear Stearns deal be structured in a way that it got done between the two firms. It took over this $30 billion portfolio from Bear Stearns not only to ensure that the deal happened, but to make sure that when markets start to open in Asia tonight, that their markets are stable and function properly.

As an economist at Goldman Sachs wrote, "We interpret these measures as an effort to get 'ahead of the curve' on the stresses and dislocations currently afflicting markets. Note in this respect that the announcement preceded the open of trading in the Tokyo Stock Exchange, signifying that Fed officials see these problems as global in nature."

Critics, and there will be many, will say that the Fed has essentially bailed out one company that made bad investment decisions and has thrown out any concerns about the "moral hazard."

In other words, it has essentially said to investors that if you take on too much risk and lose too much, don't worry, the federal government will come to the rescue.

Reacting to Friday's actions to help Bear Stearns, financing expert Janet Tavakoli called the action "a bailout for the rich."

There will be worries that the Fed now is responsible for $30 billion in assets. While the Fed won't disclose what those assets are exactly, most likely they are the very mortgage loans no one else wants.

Could taxpayers be on the hook? The Federal Reserve has billions on its balance sheet. More important, the goal of all these programs is long-term focused and to get the markets to function properly. They haven't been doing so recently. While the worry is that no one wants these assets now, at some point, perhaps months, maybe years from now, they will. When they do, they will be worth even more than their current value. But for now, to keep the market going, supporters of the Fed will say it has to be creative and take bold steps, especially as Congress and the White House debate what exactly can and should be done.

Commenting on the steps the Fed took Friday, former Federal Reserve governor Lyle Gramley said, "What the Fed is doing is trying to be as innovative as possible to deal with extremely serious and deteriorating financial situation."

And for those who would say that the actions of tonight reward people for taking on too much risk, don't tell that to the shareholders of Bear Stearns.

They just lost their shirts.