In normal times, the Federal Reserve is obligated to become the lender of last resort. The Fed does so by supplying cash to banks requiring it to prevent a systemwide breakdown. However, these are not normal times, are they?
But for this crisis, the Fed has become the lender of first resort to a whole new group of financial institutions that are relying on the central bank to boost their profits.
Instead of lending only to firms that cannot find money elsewhere, the Fed apparently is lending to firms that can get the money elsewhere, yet at a higher cost than borrowing from the Fed. I say “apparently” because almost everything about the Fed’s new primary dealer-lending facility is secret.
It has already become apparent that, whether intended or not, brokers, like Goldman Sachs, see the Federal Reserve as a very attractive resource for funds. Since the Federal Reserve is giving the money away at 2.5%, it is certainly attractive. Morgan Stanley took it a bit further saying, “it’s meant to be there for normal business. It’s not meant to be there as a last-recourse thing.”
The Federal Reserve ACT does allow the Fed to lend money beyond normal “depository institutions”, but only in “unusual and exigent circumstances.” Well, the Fed declared exactly that unanimously last Sunday as they brokered a deal for Bear Stearn’s.
What does appear to be a potential violation of the Federal Reserve Act is that the Fed is supposed to only lend to firms that can prove their inability to gain credit elsewhere, which is likely not the case for Goldman Sachs and Morgan Stanley.
And then there’s that moral hazard thing. Those institutions borrowing from the Fed’s “cheap money” bucket gain a significant competitive advantage…
Being the lender of first resort could make the Fed’s goal of stabilizing financial markets harder to achieve, because the Fed could be crowding out private-sector lending. How can anyone compete with the central bank? Any firm that doesn’t have access to the Fed’s cheap money is at a serious disadvantage.
With the Fed running out of ammunition for its other guns, it’s time they take the dust off new ones, and so they have. Just how far will it go? Nationalization of mortgages? Nationalization of the entire financial sector? Time will tell.
(Source: MarketWatch)
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