October 07, 2008
The Fed Can't Let Section 13 Go
Posted by David Zaring

The latest rescue development moves the Fed back to expanding its section 13 discount window powers still further and has absolutely nothing to do with the bailout bill.  It is the new initiative whereby the central bank would buy commercial paper directly from issuers.  That could involve a huge number of loans.  Clusterstock notes that the commercial paper market is worth $1.6 trillion and it is also seizing up.  More here and here.

Why is the Fed creating its own commercial paper operation?  Such an operation will benefit companies like GE directly, rather than as a trickle-down result of lending-at-last-resort to GE's bankers (big companies like GE issue their own commercial paper; they are faced with the prospect of offering the I guess usurious rate of 3 point something percent for the stuff these days).  But note the governance issues: Congress didn't okay this, no one even mentioned commercial paper last week.  It arguably moves the Federal Reserve into business oversight, because the agency will apparently be getting either security or money in exchange for its paper from corporations.  Moreover you could bandy about numbers backing this loan program (the money is supposed to be repaid, of course) that would make the bailout (also supposed to be repaid) look paltry. But the Fed is just doing it by regulation and a quick vote on a Tuesday.  Bernanke didn't even have to ask for Paulson's approval to do this, and I suppose if the Fed keeps coming up with new programs, we may have to re-examine who, exactly, is chairing their two-man Committee To Save The World.

How will it work?

  • The Fed will not buy the paper at a big discount.  It will use a "spread over the 3-month overnight index swap (OIS) rate," it hasn't said what the spread will be, but has mooted 100 basis points - the idea being to mimic what would happen in the commercial paper market "under more normal market conditions."
  • The commercial paper will be secured by assets, an up front fee, or a guarantee from someone else - which sounds like the way that commercial paper usually works (I'm no expert though), but underscores that this is a loan, not a subsidy, to corporate America.
  • The Fed is doing this by creating a special purpose vehicle, to which it will loan money at the "federal funds rate. Draws on the facility will be on an overnight basis, with recourse to the SPV, and secured by all the assets of the SPV."  Why the fancy footwork?  Well, for one thing, as John Carney says, "This neatly gets around any issue about whether the Fed should be in the business of making unsecured loans since it won't be lending directly to commercial paper issues."
  • The arrangement will last for 6 months, which may quell those who cry "socialism!" or "inflation!"  But, of course, the Fed can always renew the facility.  Under section 13, the Fed can, it appears, do just about anything it wants.
  • I see no evidence of a dissent here (section 13 actions do require a supermajority of the Board), but I don't think the Fed has released its minutes yet.  One wonders when some of the more free  market oriented of the governors will get off this bus.  A drop in interest rates coming next, rumor has it - that has occasioned some dissensus in the past year.

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Comments (7)

1. Posted by Michael Risch on October 7, 2008 @ 9:02 | Permalink

Why would there be a large objection by free market oriented board members. Here we have a pronounced market failure - we have customers demanding to borrow and a lack of supply for irrational reasons. The Fed can step in and actually make some money by filling that demand, assuming it offers anywhere near the market rate. While the money lending may raise inflationary and/or role of government concerns, from a free market standpoint it makes sense, I would think.

2. Posted by David Zaring on October 7, 2008 @ 9:07 | Permalink

Well, it is supposed to be the market rate "in normal conditions." Which isn't the market rate now. But yes, the Fed is seizing an opportunity to get into low-risk commercial paper on terms that you'd think someone else would find attractive.

3. Posted by jb on October 7, 2008 @ 10:39 | Permalink

When I heard about this, my first thought was 'the Fed should do a reverse auction - everyone asks for money, and the rate at which they are willing to pay' and the Fed grants $X billion in loans each day to the people who bid the highest.

That way, we don't have to 'simulate' the market clearing rate. And it's self correcting, and the Fed can control how much it lends out each day.

4. Posted by David Zaring on October 7, 2008 @ 10:59 | Permalink

They have the flexibility to set it up like that, it's an interesting idea.....

5. Posted by A Stoner on October 7, 2008 @ 12:14 | Permalink

I say that if this does as said that the bailout should be taken back. I mean, most legislators who changed their mind said they were doing it to keep money flowing to small business, right?

6. Posted by fedgovernor on October 7, 2008 @ 12:59 | Permalink

The Fed cannot do a reverse auction, because that would merely replicate what already exists.

The press would have you believe that there isn't a commercial paper market, but that's pure bullshit and the result of the level of education of your average journalist.

There is a market for commercial paper. It's a trillion dollar market. It just happens to be more expensive than some companies want to pay. It's still cheaper than borrowing money from a bank, however.

Normally, this higher price of borrowing would simply result in an overall rise in prices as companies incorporate the new higher costs into their prices.

The Fed could care less, really, how much anyone pays for money. Except that rising prices lead to demands for wages, so they feed inflation.

How can the Fed fight inflation? It can raise the cost of borrowing. Except now it can't do that, because raising interest rates leads to financial meltdowns as consumers walk away from their now too expensive ARM homeloans.

So, the only reason the Fed wants to control ABCP is that it is the only weapon it has at its disposal to control inflation.

7. Posted by Rix on October 7, 2008 @ 18:38 | Permalink

Once this is in place, it will never go away. It will be forever, like the income tax or the federal subsidy for alpaca production.

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