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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