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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About Larry M. Elkin 564 Articles

Affiliation: Palisades Hudson Financial Group

Larry M. Elkin, CPA, CFP®, has provided personal financial and tax counseling to a sophisticated client base since 1986. After six years with Arthur Andersen, where he was a senior manager for personal financial planning and family wealth planning, he founded his own firm in Hastings on Hudson, New York in 1992. That firm grew steadily and became the Palisades Hudson organization, which moved to Scarsdale, New York in 2002. The firm expanded to Fort Lauderdale, Florida, in 2005, and to Atlanta, Georgia, in 2008.

Larry received his B.A. in journalism from the University of Montana in 1978, and his M.B.A. in accounting from New York University in 1986. Larry was a reporter and editor for The Associated Press from 1978 to 1986. He covered government, business and legal affairs for the wire service, with assignments in Helena, Montana; Albany, New York; Washington, D.C.; and New York City’s federal courts in Brooklyn and Manhattan.

Larry established the organization’s investment advisory business, which now manages more than $800 million, in 1997. As president of Palisades Hudson, Larry maintains individual professional relationships with many of the firm’s clients, who reside in more than 25 states from Maine to California as well as in several foreign countries. He is the author of Financial Self-Defense for Unmarried Couples (Currency Doubleday, 1995), which was the first comprehensive financial planning guide for unmarried couples. He also is the editor and publisher of Sentinel, a quarterly newsletter on personal financial planning.

Larry has written many Sentinel articles, including several that anticipated future events. In “The Economic Case Against Tobacco Stocks” (February 1995), he forecast that litigation losses would eventually undermine cigarette manufacturers’ financial position. He concluded in “Is This the Beginning Of The End?” (May 1998) that there was a better-than-even chance that estate taxes would be repealed by 2010, three years before Congress enacted legislation to repeal the tax in 2010. In “IRS Takes A Shot At Split-Dollar Life” (June 1996), Larry predicted that the IRS would be able to treat split dollar arrangements as below-market loans, which came to pass with new rules issued by the Service in 2001 and 2002.

More recently, Larry has addressed the causes and consequences of the “Panic of 2008″ in his Sentinel articles. In “Have We Learned Our Lending Lesson At Last” (October 2007) and “Mortgage Lending Lessons Remain Unlearned” (October 2008), Larry questioned whether or not America has learned any lessons from the savings and loan crisis of the 1980s. In addition, he offered some practical changes that should have been made to amend the situation. In “Take Advantage Of The Panic Of 2008” (January 2009), Larry offered ways to capitalize on the wealth of opportunity that the panic presented.

Larry served as president of the Estate Planning Council of New York City, Inc., in 2005-2006. In 2009 the Council presented Larry with its first-ever Lifetime Achievement Award, citing his service to the organization and “his tireless efforts in promoting our industry by word and by personal example as a consummate estate planning professional.” He is regularly interviewed by national and regional publications, and has made nearly 100 radio and television appearances.

Visit: Palisades Hudson

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