What's Next for the Federal Reserve?
The Federal Reserve has cut the federal funds rate and its short-term lending rate to banks to near zero, but those moves have done little to unlock credit markets. Conventional mortgage money and business loans remain too scarce, as regional banks, which are the arteries and capillaries of our credit system, remain short of loanable funds.
Near-zero short-term lending rates for banks does little to help, because the regional banks do not lack for short-term access to funds—the Fed is providing all the near-term liquidity they want through the discount window. Rather, banks lack longer-term sources of funds to back up mortgages and commitments for medium-term lines of credit to businesses.
Since the savings and loan crisis of the late 1980s, regional banks have relied on both deposits and the sale of mortgages and other loans to money center banks in New York to finance home and business loans. Loans sold to money center banks, for many years, were securitized—that is bundled into bonds for sale to insurance companies, pension funds and other fixed-income investors. Those investors have very predicable cash flow requirements, as defined by actuarial tables, and are ideal investors for bonds backed by mortgages and other loans.
In recent years, fixed-income investors were burned by the sharp practices of New York bankers and investment houses. The latter packaged shoddy subprime mortgages into bonds, insured those bonds through the sale of questionable derivatives, and then pawned off shoddy bonds as high-quality investments. The bankers got big bonuses from the wide spreads on subprime loans and derivatives fees.
These schemes were the central to subprime crisis, housing bubble and collapse, and now the crisis of confidence on Wall Street that has poisoned credit markets globally.
Now, fixed-income investors have lots of cash to invest, but are reluctant to buy mortgage and other loaned-backed bonds. The large New York banks are not much interested in creating bonds from loans made by regional banks, because securitizing high quality loans into bonds don’t create the opportunities to write fancy derivatives that pay bankers huge bonuses.
Instead, the New York Banks have taken the massive amounts of loans and capital provided by the Federal Reserve and Treasury to go hunting for new high profit businesses and acquisitions. The presence of federal regulators in their offices keeps them from getting involved in many new schemes but does not solve the shortage of funds regional banks have to lend.
The Fed has other options. It can go out on the yield curve and buy 10-year Treasuries to pull down long rates, such as conventional mortgage rates. That would lower the rates banks pay for deposits but would not increase their deposits; hence, it would not increase the amount of money they have to make loans.
The Fed is buying mortgage-backed Fannie and Freddie Mac bonds, pulling down their rates. However, lowering rates on Fannie and Freddie securities does not make them more attractive to investors.
Ultimately, Ben Bernanke should gather the CEOs of the large money center banks, which have received direct infusions of capital from the Treasury and huge loans from the Fed, together with the biggest fixed-income investors to define the parameters of acceptable mortgage-backed securities. Then, it should require its wards on Wall Street to buy loans from regional banks and bundle those loans into bonds for sale to fixed-income investors.
The Fed could also buy bonds backed by conventional mortgages, just as it has Fannie and Freddie securities. In the end, though, the Fed may have to start lending to the regional banks against solid, prime conventional mortgages and hold the mortgages or securitize those for sale to fixed-income investors directly or through primary securities dealers. The latter are among the banks now receiving Treasury injections of capital and generous Fed loans.
This is all well outside the limits of what the Fed has done since World War II and perhaps ever done, but these are dangerous times.
Simply, the Fed is running out of conventional monetary policy and bond market options.
In the end, if the New York banks won’t do their job, the Fed may have to do it for them.