The Fed’s Role in All of This – Lender of Last Resort

Posted by marathongal

Thu Mar 20th, 2008 03:32 PM

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On Noah’s post last week about the Fed’s $30 billion bailout of Bear Stearns, one reader commented that the Fed was using taxpayer money to bail out the company.

It’s a valid thought; after all, why should the government – at the expense of taxpayers - have to pick up the tab to rescue some bank that got us into this rut as a result of the bad judgment of a bunch of rich guys? And meanwhile people are losing their homes and their jobs.

Much is being said about WHAT the Fed does, but not on HOW it does it. So what I’d like to do here is explain on a high level how the Fed operates and the impact on the US taxpayers. The reality is that it's less than people think.

For starters, when the Fed loans to a bank it requires the bank to back it up with collateral of at least 100% of the value of the loan. The collateral must meet certain liquidity guidelines and the amount depends on the collateral type (i.e. Treasury bills might only require 2% above the loan amount vs. AAA corporate bonds that might require 5%). This way if the bank defaults on the loan, the Fed is covered. Today’s Wall St. Journal includes a good article on how this works; subscription only though.

But if the collateral is gone? Well, then the Fed must run to Congress to fund at the taxpayer’s expense; but the likelihood of this would be remote.

So how does the Fed fund itself; for a primer click here for the structure of the Federal Reserve? Each Federal Reserve District Bank (there are 12 of them, plus the Board of Governors in DC) earns its own income from a spread through issuing Treasury securities and other activities it provides to banks in its respective district, i.e. money transfer services such as Fedwire. Because each Fed Bank is not allowed to operate for a profit, it must return all revenues in excess of operating expense to the US Treasury. So therefore you could argue that this is an indirect cost to the US taxpayers…though on the other hand it wouldn’t be spending anything it’s not earning in the first place.

Although the Fed has government oversight, it runs independently. This is done on purpose in order to ensure its actions are in the best interests of the economy and not politicians in Congress….and one of the reasons why the US is still considered to have the most solid financial system in the world.

So what does the Bear Stearns bailout mean for US taxpayers?

The loan that the Fed is extending to Bear - actually to JPM Chase for Bear - is secured by collateral, as noted above. If the collateral runs out the Fed must obtain funding from either borrowed funds (Treasury bonds) or – yes, you guessed it – US taxpayers. But the latter would be in dire circumstances and unlikely to happen.

Enough of the Fed…the real risk to taxpayers is new regulations permitting Fannie Mae & Freddie Mac to reduce their required capital reserves, allowing them to expand their mortgage portfolios. This actually places US taxpayers at GREATER risk than the Fed’s recent action, but doesn’t get as much notice. But that is another post for another day….