The Housing Chronicles Blog: More details on a Fed bailout

Friday, September 19, 2008

More details on a Fed bailout

The story on the federal bailout of the ailing financial services sector continues to unfold. From a story in the Wall Street Journal:

Treasury Secretary Henry Paulson announced plans Friday to quickly set up a "bold" government program to take over troubled mortgage assets from financial institutions, along with other efforts to step up the purchase of mortgage-backed securities. "The federal government must implement a program to remove these illiquid assets that are weighing down our financial institutions and threatening our economy," Mr. Paulson said in prepared remarks for a press conference. (Read the full remarks)

President George W. Bush warned that a "significant" amount of taxpayer funds will be put at risk with the government's plan to bolster shaky markets, but said intervention is necessary to keep the financial system from grinding to a halt. "This a pivotal moment for America's economy," Mr. Bush said Friday. "In our nation's history, there have been moments that require us to come together across party lines to address major challenges. This is such a moment."...

More immediately, Fannie Mae and Freddie Mac -- which were taken over by the government earlier this month -- will increase their purchases of mortgage-backed debt, he said. To facilitate that effort, Treasury will also expand the MBS purchase program it announced earlier this month.

The details weren't released for a mechanism that would take bad assets off the balance sheets of financial companies, a device that echoes similar moves taken in past financial crises. The size of the entity could reach hundreds of billions of dollars, Mr. Paulson said at a press conference.

Earlier, the Treasury announced a massive program Friday to shore up the nation's money-market mutual-fund sector, responding to concerns that the global financial crisis is starting to affect those historically safe assets. The move is designed to stem an outflow of funds as consumers start to worry about even the safest of investments, a sign of how the crisis is spreading to Main Street. There is $3.4 trillion in money-market funds outstanding.

Under the Treasury's program, the government will insure the holdings of any eligible publicly offered money-market fund. The funds must pay a fee to participate in the program...

Worried that money market mutual funds weren't liquid enough to handle a building wave of redemptions from nervous investors, the Fed said it would use its discount window to lend up to $230 billion to the industry -- via commercial banks -- against illiquid asset backed commercial paper which is widely held by money market funds...

The central bank is taking on a potentially big risk -- if these assets fall in value or default, it is potentially on the hook, because the loans, to be made through its discount window via banks, are non-recourse loans. But officials think the assets are safe and healthy ones, and see the move as a temporary measure to provide liquidity to the market. It took the step under a clause in the Federal Reserve act that allows it to lend to any firm under "unusual and exigent" circumstances.

The Fed took a second step this morning, saying it would buy short-term debt issued by Fannie Mae, Freddie Mac and Federal Home Loan Banks through primary dealers. These instruments are called discount notes, and the Fed said it would buy up to $69 billion worth of these securities to firm up this market. According to Fed staff, agency discount notes amount to about 5% of the assets of the money market mutual fund industry, so the step was another effort to provide liquidity to the market...

The administration had been taking a patchwork approach to the financial crisis, putting out fires as they ignited. The new moves represent an effort to take a more systematic approach, after a spiral of bad debts, credit downgrades and tumbling stocks brought down venerable names from investment bank Lehman Brothers Holdings Inc. to insurance giant American International Group Inc. Banks have grown unwilling to lend to one another, a sign of extreme stress, because financial markets work only when institutions have faith in each other's ability to meet their obligations...

Exactly how such an entity might be structured isn't yet clear. The possible plan isn't expected to mirror the Resolution Trust Corp., which was used from 1989 to 1995 during the savings and loan crisis to hold and sell off the assets of failed banks. Rather, a new entity might purchase assets at a steep discount from solvent financial institutions and eventually sell them back into the market.

The program may look more like the Reconstruction Finance Corporation, a Depression-era relief program formed in 1932 by President Hoover that tried to inject liquidity into the market by giving loans to banks and other businesses.

According to a top congressional aide, the Treasury department wants authority to either control the program or have it be a separate division of the government.

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