Financial Turmoil: Comparing the Troubled Asset Relief Program to the Federal Reserve's Response
Financial Turmoil: Comparing
the Troubled Assets Relief Program
to the Federal Reserve’s Response
Marc Labonte
Specialist in Macroeconomics
Government and Finance Division
Summary
As financial conditions have deteriorated over the past year, the Federal Reserve
(Fed) has greatly increased its lending to financial firms. It has also expanded the scope
of eligible borrowers to include non-bank financial firms. As of October 1, 2008, the
Fed had loans of $559 billion outstanding, compared with less than $1 billion
outstanding one year earlier. In addition, it has provided financial assistance to Bear
Stearns and American International Group (AIG).
Some have asked why these loans have not restored financial stability, and if the
purchase of up to $700 billion of distressed assets through the recently enacted Troubled
Assets Relief Program (TARP) might lead to a different result. H.R. 1424, signed into
law on October 3 (P.L. 110-343), authorizes the creation of TARP.
Financial firms have faced two broad problems over the past year — concerns
about liquidity and capital adequacy. Liquidity problems refer to the inability of firms
to liquidate assets fast enough to meet their short-term obligations; capital problems
refer to an inadequate buffer between a firm’s assets and its liabilities. The basic
difference between the Fed’s actions and those under TARP is that the Fed’s normal
activities can address only the liquidity issue, whereas TARP can address both. Some
have suggested that a program similar to TARP could theoretically be carried out
through the Fed. The Fed’s normal authority would not allow this; however, it has much
broader emergency authority. Although the Fed cannot purchase assets directly, the
assistance it provided to Bear Stearns is similar in form to the basic concept of TARP.
Financial assistance to financial firms entails similar risks to taxpayers whether it
is provided through the Treasury or the Fed. The Fed earns profits on its loans and other
investments, and each year nearly all of those profits are remitted to the Treasury. If
those loans were to yield losses, the losses would reduce the Fed’s profits, and hence its
remittances to the Treasury, causing the federal budget deficit to rise from what it would
otherwise have been.
The crux of the problem facing financial firms in the current environment stems from
the large losses on some of their assets, particularly mortgage-related assets.1 This has
caused a number of problems for the firms related to capital adequacy, which is the
difference between the value of their assets and the value of their liabilities. First, losses
and write-downs associated with those assets have reduced the firms’ existing capital.
According to Bloomberg, financial firms had written down losses of $501 billion on
mortgage-related assets and raised $353 billion in capital to compensate as of August
2008.2 Second, in the current environment, investors and creditors are demanding that
firms hold more capital than before so that firms can better withstand any future losses.
Third, the losses to date have impaired the firms’ ability to raise enough new capital.
Firms can raise new capital through retained earnings, which have been greatly reduced
for many firms by the poor performance of their assets, or by issuing new capital (equity)
and selling it to new investors. But in current market conditions, investors have been
reluctant to inject new capital into struggling firms. Part of the the explanation for this
is that current losses have made the firms less profitable. But another part of the reason
is that investors fear that there will be further losses in the future that would reduce the
value of their investment, and perhaps even cause the firm to become insolvent.
Uncertainty about future losses is partly caused by the opacity surrounding the assets that
have been declining in value, which makes it hard for investors to determine which assets
remain overvalued and which are undervalued. The result for companies such as Bear
Stearns, Lehman Brothers, AIG, Washington Mutual, and Wachovia was a downward
spiral in their stock price, which had two self-reinforcing characteristics. First, there was
little demand for existing stock because its worth would either be diluted by new capital
(raised privately or through government intervention) or lost in insolvency. Second, new
capital could not be attracted because the fall in stock value had left the market
capitalization of the firms so low. If a firm’s capital is completely depleted, there is no
longer a buffer between its assets and liabilities, and it becomes insolvent.
Many large financial firms, including the firms that have failed, are heavily
dependent on short-term borrowing to meet their current obligations. As financial
conditions have worsened, some of the firms that have had the problems described above
have had problems accessing the short-term borrowing that in normal conditions could
be taken as a given. In an atmosphere where creditors cannot perceive which firms have
insufficient capital, they become unwilling to lend for even short intervals. This is the
essence of the liquidity problem — although the firms’ assets may exceed their liabilities,
without access to short-term borrowing, the firm cannot meet its current obligations
because it cannot convert its assets into cash quickly enough (at least not if it wishes to
avoid “fire sale” prices).
The Fed has always been the “lender of last resort” in order for banks to avoid
liquidity problems during financial turmoil. To borrow from the Fed, a financial firm
must post collateral. In essence, this allows the firm to temporarily convert its illiquid
1 For more information, see CRS Report RS22963, Financial Market Intervention, by Edward
V. Murphy and Baird Webel.
2 Yalman Onaran, “Banks' Subprime Losses Top $500 Billion on Writedowns,” Bloomberg,
August 12, 2008.
assets into cash, enabling the firm to meet its short-term obligations without sacrificing
its assets. The Fed has always lent to commercial banks (depository institutions) through
the discount window.3 Over the past year, the Fed has greatly increased the scale of its
lending to banks, from daily loans outstanding of less than $1 billion before December
2007 to $351 billion as of October 1, 2008, mostly through the Term Auction Facility
created in December 2007. It has also extended borrowing privileges to non-bank
financial firms called primary dealers through the Primary Dealer Credit Facility (PDCF).4
Daily loans outstanding through the PDCF were $147 billion for October 1, 2008. In
addition, it had loans outstanding to AIG equal to $61 billion.5 Because the Fed’s normal
authority allows it to lend only to commercial banks, it used emergency powers to
authorize lending to the primary dealers and AIG under Section 13(3) of the Federal
Reserve Act.6 Section 13(3) reads as follows:
In unusual and exigent circumstances, the Board of Governors of the Federal Reserve
System, by the affirmative vote of not less than five members, may authorize any
Federal reserve bank ... to discount for any individual, partnership, or corporation,
notes, drafts, and bills of exchange.... Provided, that before discounting any such note,
draft, or bill exchange ... the Federal reserve bank shall obtain evidence that such
individual, partnership, or corporation is unable to secure adequate credit
accommodations from other banking institutions....
With direct loans of $559 billion outstanding on October 1, questions have arisen as
to why the Fed’s actions have not restored financial normalcy. Borrowing from the Fed
increases liquidity but it does not change a firm’s capital position because it now has a
liability outstanding to the Fed. So borrowing from the Fed cannot solve the problems
of undercapitalization that some firms currently face. Indeed, the Fed will generally not
lend to firms that are not creditworthy because it wants to provide liquidity only to firms7
that are solvent, and thus able to repay.
H.R. 1424, which was signed into law on October 3 (P.L. 110-343), created the
Troubled Assets Relief Program (TARP). Under TARP, the federal government is
authorized to purchase up to $700 billion in unwanted mortgage-related assets from the
balance sheets of financial firms. Proponents argue that removing the unwanted assets
from the balance sheets would remove uncertainty about future losses and allow the firms
to raise capital in private markets again. From this perspective, the program’s success
3 In normal conditions, borrowing from the discount window is allowed but discouraged, and
banks are expected to meet their liquidity needs through private markets. Soon after the financial
turmoil began, the Fed began to encourage discount window borrowing.
4 Primary dealers are about 20 large financial institutions who are the counterparties with which
the Fed undertakes open market operations (buying and selling of Treasury securities). To be a
primary dealer, an institution must, among other things, meet relevant Basel or SEC capital
requirements and maintain a good trading relationship with the Fed.
5 All data on Fed lending is from Federal Reserve, “Factors Affecting Reserve Balances of
Depository Institutions,” statistical release H.4.1, October 2, 2008.
6 For more information on the TAF and PDCF, see CRS Report RL34427, Financial Turmoil:
Federal Reserve Policy Responses, by Marc Labonte.
7 In addition, the Fed faces some statutory limitations on lending to undercapitalized banks under
normal circumstances. See, for example, Section 10B of the Federal Reserve Act.
will depend on whether it restores confidence to financial markets so that investors
become willing to invest in financial firms. In addition, proponents argue that providing
a buyer might restore liquidity to the market for these assets, boosting the prices of all
similar assets, including the ones that remain on the firms’ balance sheets. Whether the
latter occurs would partly depend on what price the government is willing to pay for the
assets, a matter that is left to the discretion of the Treasury.8
If TARP proves insufficient to restore financial calm, some have asked whether there
is any program that the Fed could operate to address the financial firms’ capital adequacy
problems. All of the Fed’s standing lending facilities involve collateralized lending, and
as discussed above, any program involving collateralized lending would not change a
firm’s capital position. According to one legal analysis, there is no express statutory
authority for the Fed to purchase corporate bonds, mortgages, or equity.9 But the Fed’s
assistance in the Bear Stearns merger with JPMorgan Chase took a form that has some
similarities to the TARP proposal. In the case of Bear Stearns, the Fed created a limited
liability corporation called Maiden Lane, and lent Maiden Lane $28.82 billion. Maiden
Lane used the proceeds of that loan and another loan from JPMorgan Chase to purchase
mortgage-related assets from Bear Stearns. Thus, although the Fed created and controlled
Maiden Lane, the assets were purchased and held by Maiden Lane, not the Fed. Similar
to TARP, Maiden Lane plans to hold the assets until markets recover, and then sell the
assets to repay its loans to the Fed and JPMorgan Chase. In addition, the Fed announced
on October 7, 2008, that it would lend to a special purpose vehicle (SPV) it had created
so that the SPV could buy commercial paper, short-term debt issued by firms that can be
secured or unsecured, for the purpose of restoring liquidity to that market. Although this
facility would not affect a financial firm’s capital position, it is another example of a
broader interpretation of Fed powers than may have existed before 2007. Both
arrangements were made under the Fed’s emergency authority under Section 13(3) of the
Federal Reserve Act.
The Fed was presumably granted broad emergency powers under Section 13(3) so
that it had the flexibility to deal with unforeseen circumstances. Nonetheless, too broad
of a reading of its powers could provoke displeasure in Congress or legal challenges.
Creating TARP within the Treasury through legislation rather than the Fed through
emergency powers avoided the argument whether such a program extended beyond the
Fed’s intended role.
Any financial transactions undertaken by the Fed, whether involving loans or asset
purchases, would have the same ultimate cost to the taxpayer as if the same transactions
were undertaken by the Treasury. The Fed’s activities generate income that results in
profits, but they also entail the potential for losses. The Fed remits about 95% of its
profits each year to the Treasury. These remittances, which equaled $34.6 billion in 2007,
finance government outlays that would otherwise need to be financed through higher
taxes or a larger budget deficit. If transactions undertaken by the Fed boost profits, then
8 For more information, see CRS Report RS22957, Proposal to Allow Treasury to Buy
Mortgage-Related Assets to Address Financial Instability, by Edward V. Murphy and Baird
Webel.
9 David Small and James Clouse, “The Scope of Monetary Policy Actions Authorized under the
Federal Reserve Act,” Federal Reserve, FEDS Working Paper No. 2004-40, July 2004, p. 29.
remittances to the Treasury will rise; if they yield losses, remittances will fall. The main
difference from the perspective of the federal budget is that transactions undertaken by
the Treasury require Congressional authorization, and transactions by the Fed do not.
Although loans made by the Fed do not require Congressional authorization, recent
loans have required the Treasury to issue additional Treasury securities. When the Fed
makes loans to financial institutions, it increases the money supply. If the money supply
were to increase too much, it could cause inflation to rise and households’ inflationary
expectations to shift upward.10 To offset the effects on the money supply, the Treasury
created the Supplementary Financing Program in September 2008.11 Through this
program, the Treasury sells interest-bearing securities to the public and deposits the
proceeds at the Fed, thereby allowing the Fed to expand its balance sheet without altering
the amount of money circulating in the economy. Thus, recent loans to the financial
system have been financed through the issuance of additional federal debt — the same as
if the loans had been made directly by the Treasury instead of the Fed.
10 For more information, see CRS Report RL34562, Slow Growth or Inflation? The Federal
Reserve's Dilemma, by Brian W. Cashell and Marc Labonte.
11 For more information, see CRS Report RL34427, Financial Turmoil: Federal Reserve Policy
Responses, by Marc Labonte.