In FED We Trust (39 page)

Ultimately, the Fed’s most powerful weapon was to simply lend more — to run the electronic printing press overtime and expand the amount of credit in the economy, or “expand the balance sheet” in Fedspeak. That balance sheet, the sum of all the loans the Fed made and securities it held, already had ballooned from about $940 billion just before Lehman collapsed to more than $2.3 trillion at the time of the December meeting. The Fed had lent more than $675 billion to commercial banks, another $50 billion to securities dealers, more than $300 billion to companies that issued commercial paper, $540 billion to foreign central banks — plus the loans to Bear Stearns and AIG.

It wouldn’t stop there, though. Fed governors in Washington had moved to lend even more in the future, including buying up to $500 billion in mortgage-backed securities and lending perhaps an additional $100 billion to government-sponsored — and now government-controlled — mortgage companies, Fannie Mae and Freddie Mac. In an attempt to reduce mortgage rates and buoy house prices, these expenditures were publicly announced. For once, something worked as planned: mortgage rates fell even before the Fed bought its first Fannie or Freddie security.

Even though the printing press had been running overtime for months, the issue of who controlled it was still contentious. In central-bank accounting terms, the FOMC, which included the regional bank presidents, managed
the size of the Fed’s
liabilities
, the sum of bank reserves and currency in the economy. The Fed board in Washington controlled the
asset
side of the Fed balance sheet, the loans it made to specific banks or the lending it did in various markets. The two were linked: assets always equal liabilities. The question was which came first: if it was the liability side — the amount of reserves the Fed put into the banking system — then the FOMC had legal authority, and the presidents had a vote. If it was the asset side — the loans that the Fed was making and securities it was buying — then Bernanke and the Fed board had legal authority, while the Fed bank presidents were bystanders.

Up to this point in the Great Panic, Bernanke had been practicing what one aide labeled “pragmatic judgmentalism,” an almost Greenspan-like approach that relied less on predictability and more on case-by-case decisions — not exactly what Bernanke had in mind when he came to the Fed. (About the only borrowers Bernanke turned away were state and local governments, because the law didn’t permit the Fed to lend to them, and the auto companies, because he said he didn’t want the Fed to be the appeals court for loans Congress initially refused to grant. The auto companies later won loans from the Treasury without Fed participation.)

This approach gave Bernanke greater discretion than the presidents wanted him to have. To bolster their case against “pragmatic judgmental-ism,” the presidents pulled out their economics textbooks: the Fed creates money that it uses to buy government securities from the banking system in open market operations. That, in turn, increases the reserves in the banking system: the more reserves, the more banks can lend. The Federal Reserve Act gave the entire Federal Open Market Committee — hence the FOMC’s name — the authority to decide how much to increase or decrease the reserves the Fed supplies to the banking system through open market operations. Instead of lending that is targeted at any particular market, the dissenting presidents wanted the Fed to simply use U.S. Treasury bonds to put reserves into the system and let the money flow to where it was needed.

It was an approach similar to one developed during the previous decade in Japan. To resuscitate the economy and fight deflation, the Bank of Japan had first dropped interest rates to zero and then, with mixed results, increased
the supply of reserves. This policy, called “quantitative easing” — because it emphasized the quantity rather than the price (interest rates) of money — suited the ideology of several Fed presidents. The Fed would control how much money was in the financial system but wouldn’t influence where it went and for what it was used — that would be up to the markets. It also gave the presidents a say: they wanted a vote on how much credit the Fed was pumping into the economy.

A few presidents even wanted to set a numerical limit on the growth of overall Fed lending. Bernanke objected. A preordained limit on the growth of the Fed’s lending would be a huge mistake. It could prevent the Fed from lending heavily at a moment when the economy was most in need of its largesse. San Francisco’s Janet Yellen sided with him: “The impact of the totality of Fed programs should not be judged by the overall size of the Fed’s balance sheet,” she said a few weeks later. “Rather, it will be necessary to evaluate the success of each individual program improving market function and facilitating the flow of credit.”
Whatever it takes
.

Bernanke didn’t think — at least in December — that flooding the system with more money would work. No matter how much money the Fed pumped into the banking system, the banks were reluctant to lend. Indeed, the banks were depositing the money back at the Fed nearly as fast as the Fed put it out. In September 2008, before Lehman, banks were parking less than $10 billion in reserves at the Fed; by mid-December, bank reserves were close to $800 billion. The credit channel that Bernanke had written about for decades was clogged: banks weren’t lending, and Japan was
not
the model. “Credit spreads” — the difference between yields on safe government debt and riskier corporate debt — “are much wider and credit markets more dysfunctional in the United States than they were during the Japanese experiment with quantitative easing,” Bernanke said.

Bernanke wanted to continue to bypass the banking system and lend directly in markets — mortgages, commercial paper, student loans — where usually high interest rates indicated the supply of credit was inadequate to meet the demand. To distinguish the Fed’s approach from the Bank of Japan’s, he wanted to call it something other than “quantitative easing.” He and the other Musketeers bandied about alternatives. Warsh offered “qualitative
easing,” but that didn’t fly. In the end, they embraced “credit easing,” a phrase Bernanke introduced into the jargon of monetary policy in his first major speech following the December FOMC meeting.

The phrase was a nice try, but it didn’t stick.

The FOMC dissenters weren’t arguing over turf alone. Targeted lending meant deciding in which markets the Fed would be intervening, a practice that ran up against the hard-line ideologies of some regional presidents. Bernanke’s critics — Philadelphia’s Plosser, Richmond’s Lacker, Kansas City’s Thomas Hoenig, and St. Louis’s Bullard — didn’t think the Fed should be picking winners and losers, for instance, deciding to buy residential mortgages but not commercial mortgages. This, they sniffed, was “industrial policy,” an epithet that conservatives use to criticize government aid to particular industries and companies.

This group drew intellectual sustenance from John Taylor, the Stanford University economist. Taylor had taken to calling Bernanke’s approach “mondustrial policy.” It was not a compliment. “What justification is there for an independent government agency to engage in such industrial policy?” Taylor asked. “Will such interventions only take place in recessions, or will Fed officials use them in the future to try to make economic expansions stronger or to assist certain sectors and industries for other reasons?”

In fact, though, the Fed was already far down the road to picking winners and losers. Bernanke and Paulson had negotiated a novel approach that turned auto, student, credit card, and small-business loans into securities. Paulson was so enthusiastic about the innovation that he publicly announced it before the Treasury and the Fed had agreed on details.

Called TALF, for Term Asset-Backed Securities Loan Facility, the program was targeted at the 40 percent of all U.S. consumer lending that didn’t stay on the books of banks — the shadow banking system, again. Before the Great Panic, outfits like Ford Motor Credit turned consumer loans for cars and
trucks into securities that it then sold to investors. By the fall of 2008, the market for those securities had disappeared, apparently because investors feared a recession so deep that more than the usual number of consumers wouldn’t be able to pay back their loans. No securitization equaled no loans, a formula that threatened to further depress consumer spending. In an economy in which banks were important, but no longer the only important channel for lending, the Fed had to broaden its reach, Bernanke figured.
Whatever it takes
.

To nourish this starved market, the Fed combined its unlimited lending with the Treasury’s new ability to put up taxpayer cash, making the Fed more comfortable with the risks it was taking. After much back-and-forth between the two institutions, the Treasury agreed to kick in $20 billion of taxpayer money from TARP to be a cushion to absorb losses. The Fed agreed to put up $180 billion, giving the TALF a total of $200 billion in loans at very sweet terms to offer hedge funds and other big investors to buy securitized consumer loans. The beauty of it was that the Treasury needed only $20 billion from its $700 billion congressionally authorized TARP to get $200 billion into the economy. “TALF shows us there are two sides to creative finance,” wrote Nobel Prize winner George Akerlof along with Robert Shiller, the Yale economist who had predicted the housing bust. “It may have gotten us into this crisis. But its genius may also get us out of it.”

The Fed and the Treasury offered investors an additional carrot to borrow this money to buy auto or credit card loans packaged into securities. If the ultimate consumer didn’t pay back the loans, then the big-money investors wouldn’t have to pay back the Fed. (The investors weren’t completely off the hook, though. To borrow $100 million to buy, say, credit card loans, investors had to post $105 million in collateral with the Fed; in a worst-case scenario, they’d lose that $5 million.)

TALF reflected Bernanke’s view of the Fed’s role in a panic: assuring consumers, businesses, and investors that it would bear the risk of possible economic catastrophe in the hope that markets would resume normal operations. As he saw it, the alternative — consumers and investors so worried about the worst-case scenario that they all hunkered down, refusing to buy or lend — was bound to make that imagined disaster a reality.

The Treasury and the Fed took months to work through all the technical and legal details and get the TALF operating. Unveiled in late November, it wasn’t even close to making its first loan when the FOMC met in December. (Even before it lent its first dollar in March 2009, the ceiling on the TALF was lifted up to $1 trillion by the Fed and the Geithner Treasury, and its scope expanded beyond consumer loans to business loans and, as Paulson had initially wanted, to commercial mortgages.)

The several Fed presidents who strongly disagreed with Bernanke’s market-by-market approach to the crisis accused the Fed of contributing to the turmoil by creating uncertainty and confusion about government policy and complained that the Fed didn’t have any “exit strategy” — a way to return to normal central banking when the Great Panic had subsided. Among them was Philadelphia Fed president Charles Plosser, who had been lecturing Bernanke privately and publicly that the Fed needed principles, not ad hoc solutions. Of all Bernanke’s ideological critics at the December meeting, Bernanke was most worried about Plosser, the only one of his ideological bent who had a vote on monetary policy in 2008. Bernanke didn’t want any dissents, and Plosser was clearly skeptical of his programs.

If the Fed was buying mortgage-backed or credit card — backed securities to lower interest rates now, asked Plosser, wouldn’t it be accused of raising interest rates when it sold the securities in the future? “Will we face challenges when we attempt to liquidate these longer-term assets from our portfolio?” Plosser continued. “Will there be pressure from various interest groups to retain certain assets? Will there be pressure to extend some of these programs by observers who feel terminating the programs might disrupt ‘fragile’ markets or that the economy’s ‘headwinds’ are too strong? Such pressures could threaten the Fed’s independence to control its balance sheet and monetary policy. We will need to have the fortitude to make some difficult decisions about when our policies must be reversed or unwound.”

Bernanke leaned on Plosser, making clear to him before and during the
meeting that the Fed needed to be united, given the fragility of the markets and the economy. Fortunately for Bernanke, though Plosser was in the same ideological camp as presidents like the Richmond Fed’s Lacker, he was also a more respectful debater and team player. Lacker was antagonistic and more inclined to make a public statement. (When Lacker got a chance to vote on a similar issue at the FOMC’s January 2009 meeting, he dissented, arguing that the Fed should avoid lending in particular markets and instead buy long-term Treasury debt to put more credit into the economy.)

As the Fed approached a vote, it became clear that this already unconventional meeting would run well past the normally reliable 1:15
P.M.
ending time. Usually, Fed staff have a solid hour after FOMC meetings to get the end-of-meeting statement prepared for worldwide transmission by wire services, Web sites, and business cable TV channels at
exactly
2:15
P.M.
Washington time.

Merely not meeting this self-imposed schedule could shake markets globally, but as 2
P.M.
neared, consensus on the wording was anything but certain. Some of the presidents wanted language that asserted the FOMC’s role in deciding the scale of Fed lending. There was talk of including a phrase in the statement that the Fed would “use its balance sheet,” but that didn’t say anything about size and composition. Finally, Christine Cummings, a twenty-year veteran of the New York Fed who was standing in for Geithner, offered a winning compromise: a vague reference in which the committee agreed to “sustain the size of the Federal Reserve’s balance sheet at a high level.” It was an artful phrase that gave the FOMC a role at least in choosing adjectives without constraining Bernanke.