Behind the Fed’s Bear Loan: Systemic Risk Fear
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The Federal Reserve’s decision to invoke a Depression-era law so that it could lend to Bear Stearns shows how seriously it believes the financial system is at risk.
Since last August the Fed has used both rate cuts and creative steps to infuse cash into the banking system and thaw markets as a whole, while striving to avoid anything that smelled like a bailout of any particular firm.
But officials concluded the collateral damage that could accompany the failure of a major player in the debt markets was a far greater threat than the moral hazard it created by bailing out one firm and possibly encouraging risky behavior in the future.
The Fed has two principal tools for lending money to market participants. It lends to its 20 “primary dealers,” including Bear Stearns, every day for up to 28 days in return for top-quality collateral such as Treasurys. But this doesn’t enable it to lend any single firm much money. It can lend unlimited sums through its discount window, but only to banks. It has, since 1932, had the authority to lend to nonbanks, but has been reluctant to use it. To underline the gravity of its use, at least five of the Fed’s seven governors must ordinarily vote in its favor.
It was last used to make loans during the Depression. The Fed invoked the clause in 1970 to lend to companies cut off from the commercial paper market by the failure of the Penn Central railroad, but did not end up lending any money.
“I would be very cautious about opening that window up” to investment banks, Fed Vice Chairman Donald Kohn told Congress on March 4. Banks get access in part because they are subject to “extensive” supervision, he said.
On Thursday, Fed officials, including New York Fed President Timothy Geithner, Mr. Kohn, and Chairman Ben Bernanke were in regular contact with Treasury Secretary Henry Paulson and the Securities and Exchange Commission about Bear’s condition.
By day’s end, Bear’s efforts to secure a rescue came up empty. Like most securities dealers, Bear had borrowed heavily with overnight “repo” loans from money-market funds. If it failed to pay them back Friday, Bear’s collateral could be dumped in a fire sale and other dealers could see their repo loans tighten up as well.
Around 5 a.m., regulators including Mr. Geithner, Mr. Bernanke, Mr. Paulson and Mr. Steel convened by conference call. At the end of the call, around 7 a.m., Mr. Paulson called President Bush, who was due to speak on the economy in New York.
Mr. Geithner contacted Bear Stearns to alert them to the Fed’s decision. With one governor on a flight back from Europe and two seats vacant, the Fed had to invoke another section of the law to allow just four governors to approve the move. J.P. Morgan Chase & Co. is the conduit for the loan because it already has access to the discount window, is supervised by the Fed, clears for Bear and knows the firm well. But if Bear fails and the collateral is insufficient to cover the loan, the Fed, not J.P. Morgan, takes the loss.
–Greg Ip, with Michael M. Phillips |
