Fed and Treasury unveil new direction

Last week, I attempted to explain, before the Senate and House had voted on the bailout package, why the package was needed and what, precisely, the economic consequences of inaction would be should we fail to enact the new legislation. Unfortunately, the congressional vote occurred before I had a chance to fulfill my promise to explore some alternatives to the bailout plan on the table.

I had been kicking around an idea that I thought would be too radical and a non-starter, which was for the Fed to purchase/provide directly the short-term corporate debt at risk in today’s credit markets instead of propping up the failing financial intermediaries who generally supply it to companies. My thinking was that if the overhang of mortgage-backed securities (MBS) was creating a situation where banks wouldn’t lend to Main Street businesses, let alone each other, then the Fed should simply work around the banks and supply short-term financing to businesses directly.

While risky and expensive, the virtue of this approach is that you wouldn’t need to bail out anybody…just allow the sickly banks to expire and carry their MBS to the grave. The drawbacks would have been short-term chaos in the financial industry (but how’s that different from the current situation?); the introduction of certain conflicts of interest for the Fed; certain legal impediments regarding potential market losses; and the federal government being on the hook for an indeterminate amount of time for potentially well over $1 trillion in short-term debt.

Everyone to whom I presented this idea responded with either incomprehension or derision, but apparently, when the boys at the Federal Reserve came up with roughly the same thought, nobody laughed. This morning, the major newspapers (here and here are excellent articles) are reporting that the Fed will indeed commence purchasing unsecured short-term debt as a means to unlock the frozen credit markets.

The astonishing thing to me is not that the government is contemplating a direct intervention into the commercial paper market, but rather, that it is considering this on top of the bailout of failed banks. Of course, at this early stage, very little of the $700 billion (or whatever the final figure is or will be) is actually committed, but it’s hard to see how the Fed can adequately bail out financial institutions and provide a last-resort buyer for commercial paper without stoking some seriously high inflation rates.

Best that I can tell, part of the game here is not just throwing money at the problem, but being clever about when we deploy the cash. For instance, short-term paper facilities last no longer than 270 days before a roll over is needed. Other emergency measures created by the Fed, such as the Term Auction Facility, have even shorter loan terms.

On the other hand, snapping up the rotting mortgage-backed securities for which the bailout was intended could take a long time. These instruments are incredibly complex, and no two instruments are the same due to the sophisticated formulas by which mortgage debt was sliced and diced. In other words, it could take the Fed a long time to figure out which MBS to buy and in what sequence.

This gives the Fed time for a direct intervention in the short-term paper market, and we shouldn’t be any worse off for it from a monetary standpoint, assuming that the intervention works. If, however, the Fed must tie up a massive sum of money in short-term paper for an extended period of time because the credit markets aren’t responding, well, that’s a bad thing for so many different reasons.

This direct intervention into the credit markets was the alternative I was thinking of last week…I just thought we should do it without bailing out the banks at the same time. Maybe the Fed is thinking that it is more efficient to save so much financial infrastructure from liquidation, rather than needing to rebuild it later when the markets recover, but my preference is that sick banks and failed bankers get wiped out.