Crisis Basics - What Else Can the Fed Do?

In the preceding post, I implied that the Federal Reserve can't do a whole lot about the current economic crisis that's unfolding. It can create money to lend, but not the means to service the loans. It can influence mortgage rates, but it cannot set them. Not only that, but if it shows too much mercy and makes too much money, bond traders could decide that inflation's on the way and send interest rates soaring.

But there are wrinkles. Remember when I described how the Federal Reserve creates money by buying and selling government bonds to and from banks? Nowhere is it written that the Fed can only buy government bonds. If it wants to, it can buy mortgage bonds. Or corporate bonds. Or government bonds. Or options. Or futures.

The Federal Reserve, a/k/a Corporate Bailouts 'R' Us

In fact, the Fed has done all of those things at times. On October 20, 1987, the day after the Dow Jones lost 22% in value, Federal Reserve brought stock index futures in Chicago for the purpose of manipulating the stock market upward. This action wasn't revealed for several months; since then, a so-called "Plunge Protection Team" has operated to keep the U.S. stock market steady during periods of turmoil.

The PPT is controversial -- among other things, it begs the question of just how "free" U.S. markets really are -- but there's plenty of evidence that it exists. A long time ago, someone who I trusted told me that the Fed found a way to bail out some major insurance companies from their bad commercial real estate loans of the 1980s. God only knows how they did it, but I believed the story then and I still believe it.

And there are suggestions that in August 2007, the Fed started buying mortgage-backed bonds to keep the American mortgage market from locking up. I doubt we'll ever know for sure. As for whether it worked, the jury's out: mortgage originations collapsed by 50% in August, and September is anyone's guess.

The Fed: Meet your new landlord?

Want to get freaky? Well, one thing the Fed could do, at least in theory, is become a mortgage lender in its own right, most likely by refinancing existing mortgages at lower rates. A more plausible "radical idea" would be for Congress and/or the federal regulators to raise the limits on the mortgages that can be held by Freddie Mac and Fannie Mae, and encourage them to buy busted mortgages. (If that works like, say, Medicare Part D, the prescription drug benefit, they'd even forbid Freddie and Fannie from buying bad loans at a discount!) Then, as those loans go bad, the Fed would bail out Freddie and Fannie.

Voila! Problem solved! Not for the borrowers, mind you. They'd still be kicked out of their houses. But the lenders would be made whole. And isn't that the point of any bailout, to rescue the banks? This IS America. He's who's got the gold makes the rules, even if there's no gold.

For now, I think the Fed will stick to its more traditional tools: creating credit by buying government bonds and/or repos through the its New York open markets desk, and from time to time intervening to calm "disorderly markets." If there's a bailout, I think they'll try to use the traditional tools. If it goes out of control, I think they'll first try to consolidate the bad loans into Freddie and Fannie, and then bail them out.

Door #1: Frying Pan. Door #2: Fire.

It's not as if the traditional Fed tools are without controversy. Indeed, most people, myself included, think the Fed is in something of a tight spot as it tries to calm stormy markets and head off a mortgage meltdown:

1. Is the Fed spitting in the ocean? The U.S. mortgage bond market is far bigger and more complicated than the U.S. stock market. Not only that, but it's closely connected to other financial markets: for corporate and government bonds, for options and futures based on the bond trading, for stocks of companies affected by interest rates and the servicing of loans. Putting aside the question of whether it's the Fed's business to bail out irresponsible lenders and borrowers by buying up mortgage bonds, there's a real issue of whether a Federal Reserve bailout would be a Pyrrhic victory.

2. What about inflation? This would be the likely cost of a Fed bailout of the residential real estate debacle. Let's make one thing clear: If a "successful" bailout meant wiping out debt or rendering it meaningless, the Fed can do it by buying it all back with dollars it creates out of thin air. The result, however, would be hyper-inflation. Those old mortgage bonds would be "paid off," but you wouldn't want to see the interest rate that a buyer of a newly-issued mortgage bond would demand in return for buying it. Does anyone remember the inflation of the 1970s? I do. It sucked. It was even a little scary.

That, in a nutshell, is the financial paradox that confronts the Federal Reserve: stand fast against a bailout and see a financial collapse, or give in to the siren song and watch inflation take off like a rocket. In a future essay, I'll translate this into the real economy where everyone works and plays. I bet you're on the edge of your seat. Hint: Put on your disco shoes. Stagflation's coming back!