One of Bernanke’s goals was to reassure the public that the many new loans that the Fed is extending and assets it is purchasing do not pose a significant risk to taxpayers. From Bernanke’s remarks:
Importantly, the provision of credit to financial institutions exposes the Federal Reserve to only minimal credit risk; the loans that we make to banks and primary dealers through our various facilities are generally overcollateralized and made with recourse to the borrowing firm. The Federal Reserve has never suffered any losses in the course of its normal lending to banks and, now, to primary dealers.
Left unsaid here is the fact any private lender could equally well have also extended said overcollateralized loans to these same borrowing institutions, but decided that the compensation for absorbing such a risk was inadequate. Bernanke’s core assumption is thus that private lenders are currently mispricing risk, but the Fed can do it correctly. I’m prepared to believe that’s true– there is some degree of overcollateralization that might be inadequate for markets but should be sufficient for the Fed, but what is it? Are the underlying assets really worth 99 cents, 90 cents, or 50 cents on the dollar? Should the overcollateralization therefore be 1%? 10%? 100%? The devil is in the details, and whatever details we know about this aren’t coming from the Fed.
Nor do I take comfort in Bernanke’s observation that the Fed hasn’t lost any money on the new facilities– yet. Didn’t the buyers of subprime MBS say the same thing? It was the wrong answer then for the same reason it’s the wrong answer now– when you drastically change the scale and rules of the game, you can’t base your risk assessment on historical performance. The one thing of which we should be confident at the moment is that the future won’t look like the past.
Bernanke also discussed some of the Fed’s new plans:
In addition, the Federal Reserve and the Treasury have jointly announced a facility that will lend against AAA-rated asset-backed securities collateralized by student loans, auto loans, credit card loans, and loans guaranteed by the Small Business Administration. The Federal Reserve’s credit risk exposure in the latter facility will be minimal, because the collateral will be subject to a “haircut” and the Treasury is providing $20 billion of capital as supplementary loss protection. We expect this facility to be operational next month.
Here at least we have a number– $20 billion– that will give us some idea of what Bernanke assesses the ballpark risks to be. If, for example, we see that the Fed lends $100 billion in this program, I’d take that to mean he’s thinking the underlying assets are really worth at least 80 cents on the dollar; if $200 billion, we’re talking about 90 cents on the dollar. If this gets into the hundreds of billions, it’s hard to see how $20 billion would be regarded as a significant equity cushion.
Bernanke also addressed the question of what’s the exit plan for bringing the Fed’s balance sheet back to normal size and safety:
However, at some point, when credit markets and the economy have begun to recover, the Federal Reserve will have to unwind its various lending programs. To some extent, this unwinding will happen automatically, as improvements in credit markets should reduce the need to use Fed facilities….
As lending programs are scaled back, the size of the Federal Reserve’s balance sheet will decline, implying a reduction in excess reserves and the monetary base. A significant shrinking of the balance sheet can be accomplished relatively quickly, as a substantial portion of the assets that the Federal Reserve holds– including loans to financial institutions, currency swaps, and purchases of commercial paper– are short-term in nature and can simply be allowed to run off as the various programs and facilities are scaled back or shut down. As the size of the balance sheet and the quantity of excess reserves in the system decline, the Federal Reserve will be able to return to its traditional means of making monetary policy– namely, by setting a target for the federal funds rate.
That sounds to me like an exit strategy for how to get out of this if everything works out just right and the problems all go away.
And what’s the exit strategy if it doesn’t work? I suppose more lending facilities.