Analysis
When the Fed goes into the investment business
By Rodrigue Tremblay
Online Journal Guest Writer


Apr 14, 2008, 00:12

"The power to determine the quantity of money . . . is too important, too pervasive, to be exercised by a few people, however public-spirited, if there is any feasible alternative. There is no need for such arbitrary power . . . Any system which gives so much power and so much discretion to a few men, [so] that mistakes -- excusable or not -- can have such far reaching effects, is a bad system. It is a bad system to believers in freedom just because it gives a few men such power without any effective check by the body politic -- this is the key political argument against an independent central bank." --Milton Friedman (1912-2006)

"The system of banking [is] a blot left in all our Constitutions, which, if not covered, will end in their destruction . . . The issuing power should be taken from the banks and restored to the people to whom it properly belongs." --Thomas Jefferson, (1743-1826), 3rd U.S. President

"If the American people ever allow private banks to control the issue of their money, first by inflation and then by deflation, the banks and corporations that will grow up around them [around the banks], will deprive the people of their property until their children will wake up homeless on the continent their fathers conquered." --Thomas Jefferson, (1743-1826), 3rd U.S. President

In 1989, the U.S. government created the Resolution Trust Corp., in effect nationalizing many savings and loans banks that were in financial difficulties. Similarly, on February 16, 2008, the British government nationalized the Northern Rock bank and rescued this bank with about �55 billion ($107 billion) in public loans and guarantees.

During the weekend of March 14-16, 2008, the Federal Reserve, a semi-public and semi-private American central bank organization, created a Delaware-based corporation in partnership with a (regulated) private bank, the JP Morgan Chase bank, in order to buy and manage $30 billion of distressed mortgage-backed securities acquired from a New York-based global but unregulated investment bank, Bear Stearns, about to go bankrupt. JP Morgan Chase put $1 billion in the new corporation, while the Fed invested $29 billion, an amount that was quickly transferred to JP Morgan Chase, the new owner of Bear Stearns.

In so doing, the Fed has de facto nationalized a portion of the portfolio of Bear Stearns, and become an "investor of last resort" rather than a "lender of last resort," besides facilitating the takeover of this investment bank by JP Morgan Chase. A private company, BlackRock Financial Management, was also hired to administer the new Delaware-based corporation and will attempt to liquidate the acquired securities gradually over time. The Fed could then recuperate part or all of its non-recourse "loan" to JP Morgan Chase, and would retain any excess amount on its unusual "investment," in the event there is a profit.

There you have it. For the first time since its creation in 1913, the Fed has turned itself into a government of the banks, and has invested risky public capital in a business that was in need to be saved quickly from bankruptcy and liquidation. Thus, the Fed has not only decided that it is its duty to solve "liquidity crises," but also "solvency crises" in the regulated and non-regulated banking sector. In other countries, such public investments to resolve a solvency crisis are decided and handled by the treasury and the government, and are later voted into law. Even in the U.S., that is the way the Resolution Trust Corp. was created by the Reagan administration in the late 1980s. In fact, the current banking crisis is very reminiscent of the U.S. Savings and Loan crisis of the 1980s and 1990s, although this time the banking crisis is much more severe and much more widespread.

I personally do not question the need for avoiding a panic liquidation of the subprime and other exotic assets of Bear Stearns, in order to avoid a contagious domino effect of bank failures and a worldwide credit crunch, which could have duplicated the failure of the Creditanstalt bank in September 1931, an event that precipitated the 1930s depression. After all, the Fed was established in 1913 to avoid banking panics. What can be questioned is the way this has been done, the end result being in effect to subsidize the U.S. banking sector by privatizing most of the profits derived from the rescue operation in the hands of a private bank, and nationalizing the most likely losses in the hands of the Fed and its backer, the U.S. government. The U.S. Treasury should have played a much larger role in this bailout, so as to protect the public interest.

Make no mistake about it. This transaction may turn out to be enormously profitable to JP Morgan Chase, if the actions of the Fed were to stabilize the market for mortgage-backed financial assets in the coming months, while the Fed guarantees that the new owner of Bear Stearns would not suffer any loss on a vulnerable portion of its acquired portfolio.

A more transparent and a more democratic approach would have called for the Treasury to establish the equivalent of the old Resolution Trust Corp. to acquire insolvent Bear Stearns and gradually liquidate its mortgage-backed and other risky financial assets over time. The salvaged investment bank could have later on been sold to an existing bank at a fair market value, or reinstated as an independent viable financial entity. The public good could have been protected by avoiding a financial panic, while simultaneously precluding a massive liquidation of jobs at Bear Stearns, and a possible private enrichment of a private entity under the umbrella of an unusually risky public investment by the Fed.

I have been an adviser to central banks over my career, and that is what I would have recommended.