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A Tough Word

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  • | 6:00 p.m. August 25, 2008
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A Tough Word

From a large plate of difficult questions for Federal Reserve Chairman Ben Bernanke comes this: Which financial institutions can he save and which ones does he have to let fail?

MARKETS by Craig Tores | Bloomberg News

Ben Bernanke is still trying to define which financial institutions it's safe to let fail. The longer it takes him to decide, the tougher the decision becomes.

In the year since credit markets seized up, the 54-year-old Federal Reserve chairman has repeatedly expanded the central bank's protective role, turning its balance sheet into a parking lot for Wall Street's hard-to-finance bonds and offering loans through its discount window to investment banks and mortgage firms Fannie Mae and Freddie Mac.

The lack of clearly defined limits may put the Fed's independence at risk as Congress discovers that its $900 billion portfolio can be used for emergency bailouts that might otherwise require politically sensitive appropriations and taxes.

"There is some hard thinking that needs to be done," says Philadelphia Federal Reserve Bank President Charles Plosser. "The Fed has a terrific reputation as a credible institution. We have to be cautious not to undertake things that put that credibility at risk."

The expanding role of central banks has been a hot topic among federal banking officials for most of the summer; Bernanke addressed the issue in front of an international gathering of banking and financial gurus at the a Fed symposium held in Jackson Hole, Wyo., earlier this month.

Since taking on $29 billion in Bear Stearns Cos. assets to facilitate the failing firm's takeover by JPMorgan Chase & Co., Bernanke has made several moves that imply further expansion of the central bank's mission.

Student-loan collateral

Bernanke granted a congressional request to accept bonds backed by student loans as collateral for Fed securities loans. And he didn't object when Congress inserted a provision into the housing bill signed into law last month that makes it easier for the Fed to lend to failed banks under government control.

"They want to placate the Congress and the financial markets," says Fed historian Allan Meltzer; doing so, however, he says, sets a "terrible precedent."

Policy makers are aware of the concern. The Federal Open Market Committee has ordered a formal study of the implications of the Fed's broader role in fostering financial stability, drawing on research from throughout the Fed system.

Under Bernanke's predecessor Alan Greenspan, the Fed drew a clear line against using its portfolio to influence specific markets. An internal study published in 2002 warned that "the favoring of specific entities" might "invite pressure from special-interest groups."

And earlier this year, just three days after the Fed approved a loan against Bear Stearns securities, U.S. Rep. Paul Kanjorski, D-Scranton, Pa., and 31 other lawmakers sent Bernanke a letter asking him to open the discount window to nonbank education-loan companies. Bernanke refused.

The 2002 study said such pressures "could pull the Fed into fiscal debates" and "compromise its objectives" for monetary policy: keeping employment high and inflation low.

"How can you be independent on one score and dependent on another?" asks Vincent Reinhart, former director of the Fed's Monetary Affairs Division, who advised both Bernanke and Greenspan. Officials, he says, "are overburdening the Federal Reserve, and that sets up the potential for multiple conflicts. They use up their credibility on nonmonetary issues, they lose their independence and they dilute their expertise."

Reinhart, now a resident scholar at the American Enterprise Institute in Washington, is one of several Fed alumni who say they are concerned the central bank will next face requests to rescue hedge funds or insurance companies whose failure might damage the financial system.

Hard to say no

"It is much harder to say no when you have the precedent," says J. Alfred Broaddus Jr., former president of the Richmond Fed. "Congress needs to find a way to structure something else to take the Fed out of this."

The Fed chairman's decisions are a decisive break with Greenspan's aversion to government interference in markets, a conviction that even permeated the central bank's day-to-day operations.

On Aug. 10, 2005, when Greenspan was chairman, 94% of the Fed's $24 billion in outstanding repurchase agreements with Wall Street were in U.S. Treasury notes. On Aug. 10, 2008, only 14% were in Treasuries, with the rest in mortgage bonds and agency securities, according to Wrightson ICAP LLC in Jersey City, N.J. The New York Fed says agency and mortgage-backed securities "became more attractive."

"They have had to abandon all principles that guided their earlier debates," says Lou Crandall, chief economist at Wrightson. The objective now is "how you get the most market impact."

To Bernanke, the decisions of the past 12 months may well have protected the Fed's independence from far greater erosion that might have occurred if the central bank had stood aloof while financial markets melted down.

The former Princeton University scholar views the Great Depression as a fiasco that compromised the Fed's credibility, bringing an onslaught of regulation and a congressional review of the Federal Reserve Act. If the Fed had walked away from Bear Stearns, it would have led to higher unemployment, a deeper downturn and a longer recovery, all of which would have brought even greater political pressure on the Fed, the chairman's defenders argue.

"It is not an easy sell," Bernanke told Senator Evan Bayh, an Indiana Democrat, during an April 3 hearing on the Bear Stearns rescue. "But the truth is that the beneficiaries of our actions were not Bear Stearns and were not even principally Wall Street. It was Main Street."

Bernanke added that "the financial system has been under a lot of stress and that has affected our ability to grow. It has affected employment. It has affected credit availability."

Bernanke's actions have been informed by his own research with New York University's Mark Gertler showing that damaged banks accelerate economic downturns.

That threat has multiplied in a new financial system where mortgage lenders may not even be banks, and mortgages are warehoused in funds off the books of banks.

"We are in a new environment, and the Fed had to do something different," Gertler says. "Moving forward, the regulatory structure has to adjust."

Fed officials have been cautious about suggesting what new supervisory powers they would like or how their lender-of-last- resort powers should function in the future.

Expanding authority

Bernanke said in a July 8 speech that a "strong case can be made" for expanding the Fed's authority over the U.S. payment system, the complex network of financial plumbing that handles the exchange of money from such transactions as options trades in Chicago and stock sales in New York. The Fed also is pushing for better settlement and trading systems for securities that aren't bought and sold on exchanges.

Beyond that, the Fed chairman has expressed wariness over the U.S. Treasury's recommendation that the Fed become the "market-stability regulator."

"Attention should be paid to the risk that market participants might incorrectly view the Fed as a source of unconditional support," he said in the July 8 speech.

Even so, the Fed has already expanded its supervisory reach. It has become a temporary consulting regulator of Fannie Mae and Freddie Mac, working with the Office of Federal Housing Enterprise Oversight.

An agreement with the Securities and Exchange Commission allows the Fed to make recommendations on the capital and liquidity positions of investment banks.

The Fed is also more actively using its authority to supervise nonbank consumer-finance subsidiaries of bank holding companies, such as the CitiFinancial unit of Citigroup Inc.

To "a large degree," it appears the Fed "is going to become a major regulator of financial institutions," says Ross Levine, a Brown University economist who has written a book on bank regulation.

With that comes the danger that measures the Fed has to take to enhance stability may end up restraining economic growth, Levine says.

"That can come at a very big cost to innovation and the welfare of the country," he says.

Plosser, the Philadelphia Fed president, says the central bank is struggling internally with such concerns.

"What has been put on the plate is the broader role of central banks in their effort to promote or ensure financial stability," he says.

"We have to face up to the potential risks to the conduct of sound monetary policy from acquiring these other responsibilities."


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