Trillion Dollar Bailouts Equal Crony Capitalism
Earlier this week, Federal Reserve Chairman Ben Bernanke sent a letter to Congress where he tried to counter the idea that the Fed secretly lent trillions of dollars to banks during the financial crisis. But Bernanke’s complaint missed the whole point of why the nation should be up in arms over the Fed’s special bailout of Wall Street. Arguing over whether $7.7 trillion or $16 trillion was the total amount of the bailout ignores the deeper issue of the Fed’s abuse of its mandate to be “lender of last resort.”
The lender of last resort (LLR) idea was first developed in the 19th century by two British economic writers, Walter Bagehot, who coined the phrase in his book Lombard Street, and Henry Thornton, considered to be the father of the modern central bank.
Essentially, a lender of last resort should be an institution that protects the monetary system from contractions in the face of bank runs and financial panics—i.e., it makes sure there is money to borrow if liquidity freezes without good cause. The supporting thesis is that if a company is healthy, with good collateral to put on the line for a loan, but can’t find a lender because of an abnormal lock-up of money, they shouldn’t be forced to fail. In this instance, a LLR can step in and prevent an unnecessary bankruptcy and “lend freely, but at a penalty rate,” as Bagehot wrote.
On this logic, many have defended the Federal Reserve’s recent lending not as a bailout, but as fulfilling its duties as lender of last resort. The problem with this logic is that the Fed’s emergency lending programs have deviated far from the classical model of the LLR. The Fed did not lend to creditworthy borrowers, it did not ensure good collateral for the loan, and it did not charge an interest rate above the going market rate (a “penalty rate” to avoid banks becoming dependent on the source of funds).
Let’s consider each of these accusations and the evidence.
First, the most important principle for LLRs is that they only lend to solvent companies that would otherwise be able to get a loan from the private sector. If a firm is unsound and failing it will naturally have trouble getting access to credit and go bankrupt. The LLR exists for the times when healthy companies can’t get credit for extraordinary reasons but are otherwise healthy institutions. To highlight how far away from this principle the Fed has ventured, consider the financial institutions that the Federal Reserve has recently lent to:
American International Group—so full of toxic credit default swap contracts that it couldn’t get a loan at any price and was hours from running out of cash before the Fed stepped in with an initial $85 billion loan. It’s equity has since been diminished to near zero value.
Bank of America—weighed down by losses from bad mortgage investments on its books so large that it required $94.1 billion in loans and has remained teetering on the edge of technical insolvency ever since.
Citigroup—facing a $18.72 billion total loss for 2008, it borrowed $99 billion over a six day period in January 2009.
Morgan Stanley—took $107 billion in Fed loans in September of 2008 and still posted a massive $2.3 billion loss in just the fourth quarter of 2008 alone (10 times the consensus estimate of bank analysts at the time).
The list could go on for pages because the Fed lent to nearly any financial institution it could find. And since no one could convincingly value all those toxic mortgage-backed securities during the height of the crisis (one of the reasons Treasury Secretary Henry Paulson decided to use TARP for equity injections instead of buying the toxic debt from the banks directly), it is hard to see how the Fed could justify determining that all the financial firms it lent to were creditworthy. The Fed knowingly violated the foremost tenant for a lender of last resort.