Why $1.2 Trillion Is No Big Deal

Even in these days of scary-big numbers, like $15 trillion of accumulated federal debt, $1.2 trillion would usually still be a big deal. But sometimes, it just isn’t.

The recent flap over the Federal Reserve’s open-ended lending to big banks during the 2008-2009 financial crisis and its aftermath is one of those situations where $1.2 trillion really does not amount to much, despite some breathless press coverage to the contrary.

The contretemps broke out with an article Bloomberg published on its website on Nov. 28 under the headline, “Secret Fed Loans Gave Banks $13 Billion Undisclosed to Congress.” The story was based in part on data that Bloomberg and Fox News extracted from the Federal Reserve System under a Freedom of Information Act request that the Fed honored only after it lost a court fight. The information, augmented by data the Fed was required to release after the Dodd-Frank financial reform overhaul was enacted last year, showed that the Fed had $1.2 trillion in short-term loans outstanding to the banks at its peak. Those banks ultimately repaid all the money.

Were these really “secret Fed loans?” Did they really give banks “$13 billion undisclosed to Congress?” For that matter, should anyone care? I believe the answer to all of these questions is “not really.”

That puts me more or less in the same corner as the Fed, which posted a four-page memo claiming articles (including the Bloomberg one, which it addresses point by point without naming explicitly) based on the newly-released data contained “egregious errors.” Bloomberg, in turn, stood by its story.

In the fall of 2008, banks were afraid to deal with one another because no one knew which institutions were solvent in the wake of Lehman Brothers’ collapse. The Fed stepped in and provided the funds that banks needed to maintain their day-to-day operations, which, in turn, helped banks to gradually regain their confidence in one another as the crisis passed.

This sort of borrowing from the Fed is called the “discount window.” The Fed usually charges a premium for banks to use the discount window, but when everyone was terrified, borrowing rates between banks were so high that the discount window was the cheaper and more accessible option. So banks borrowed from the Fed. A lot.

Banks, of course, try to make money, just like every other business. One way they make money is by borrowing money from depositors or other sources, including the Fed, and then lending it at higher rates.

Banks really needed to make money in the aftermath of the housing meltdown and Lehman’s failure. The Fed conducted its first round of stress tests in mid-2009 to try to restore confidence in the banking system. The liquidity cushion that the Fed provided through its discount window helped banks make it through the stress tests, and the profits the banks made on the Fed’s loans helped rebuild their depleted capital. These, as they say, are good things.

Though the statistics in Bloomberg’s article are interesting, they are not terribly surprising. We already knew that the Fed was lending large sums to banks. Now we know that it peaked at $1.2 trillion, and we know exactly which banks were doing the borrowing, and how much.

We also knew all along that banks were lending that money back out for a profit. Because the economy was slow, loan demand from consumers and businesses was light, so the banks lent a lot of the Fed’s money right back to the government, to finance its massive deficits. The practice was a source of low-cost borrowing for the Treasury, which needed cash in order to stimulate (or at least to try to stimulate) the economy.

The larger arguments and conclusions in the original Bloomberg piece strike me as overstated. Bloomberg made up the headline’s $13 billion figure, which it says represents the theoretical income the banks made from what they borrowed. Bloomberg knew what the banks paid for the loans, and it knew, on average, what banks made on the money they lent out (known as the “net interest margin”).

It doesn’t follow that every dollar borrowed from the Fed could be lent at net margin; in fact, it’s virtually certain that not every dollar could be, since the net margin averages the interest paid to banks by all sorts of borrowers on all sorts of loans. Most of the money borrowed from the discount window was most likely parked in Treasury securities, which paid only a little more in interest than the banks paid the Fed. The difference was slight, so the profit was too. Banks, however, could use these Treasury securities to settle debts among themselves, which made them liquid. This liquidity was the whole point of the Fed’s open-ended discount window lending, and the policy succeeded.

Did the Fed really “give” banks $13 billion? If so, from whom did the Fed take the money? If the profit came from the Treasury’s borrowings, you might argue that taxpayers gave banks the money – except that if the banks had not been able to lend that money to the Treasury, the Treasury would have had to borrow the same amount of money elsewhere, at higher rates. The program did not cost taxpayers money; it saved them money.

Bloomberg’s article argues that banks claimed they were profitable and financially sound even while turning to the discount window. While historically these actions would have been contradictory, the past few years have not been ordinary times. The discount window was readily available as a source of low cost funds. Even stable banks could use it to get stronger as a result. Those banks behaved rationally by taking advantage of the opportunity the Fed provided.

The wisdom of the Fed’s strategy can be seen in two results. First, all the discount window loans were repaid. Second, we haven’t seen another Lehman Brothers. The financial system is recovering from the worst crisis since the Great Depression.

I’m glad I can see the numbers Bloomberg fought for, so kudos to the journalists for that. But I see nothing in the figures to be outraged about.

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