News reports have announced that the Federal Reserve has infused the economy with billions of dollars to promote stability and liquidity in the financial markets. Does this mean that these actions are using tax payer money to bail out banks and other financial institutions?
UPDATE 9/18: World's major central banks coordinate efforts to put more cash in global markets.
The AP has reported a coordinated effort for the world central banks to inject as much as $180 billion into the world economy. The joint effort includes the Federal Reserve, the European Central Bank, the Bank of Canada, the Bank of England, the Bank of Japan, and the Swiss National Bank.
Russia was conspicuously absent from this coordinated effort of the major central banks
The infusion seems to be intended for short term relief as a response to the many investment bank struggles this week - Lehman Brothers, Merril Lynch, HBOS, AIG, Washington Mutual, Morgan Stanley and others.
Early market response seems favorable.
Later news reports today tell more detail about the cause of the sudden central bank action. Evidently there was overnight a loss of faith between banks in their willingness to make inter-bank loans. The cash infusion was to address this issue which was locking down the banking system.
There are some real problems with the financial markets. Its beginning to appear that all the facts are not yet out.
What is managing the economy's cash supply?
Where does this money come from?
Where does this money go?
How does someone infuse an economy with billions of dollars?
Is this action inflationary?
Is the government printing money that has no real value?
How does the Federal Reserve manage the money supply?
The Federal Reserve was established in 1913 to promote sustainable economic growth and to stabilize the money supply. Its roles today are broadly to set monetary policy, to regulate depository institutions, and to provide financial services for the Treasury Department and banks , but all relate to ensuring stable economic growth.
In the role of managing liquidity in the economy, the Federal Reserve uses 3 monetary policy tools, setting the rates for bank to bank lending, setting the reserve requirement for banks and other depository institutions, and most importantly managing the open market operation.
The Federal Open Market Committee is most known for setting the Federal Funds interest rate. It meets 8 times yearly. Managing open market operations refers to the buying or selling of treasury securities. When the Federal Reserve buys Treasury securities it puts cash into the banking system. This increases bank reserves and supplies money for loans. When the Federal Reserve sells Treasury securities, it takes cash from the banking system. This reduces bank reserves and removes money for loans.
If too much money is in the system, then inflation can result.
If too little money is in the system, then recession can result.
This open market action is not targeted towards a specific bank or institution, as the recent bail outs of Fannie Mae, Freddie Mac, and AIG. These actions actually are loans or investments given to the specific institutions. Tax payer money is actually at risk in these transactions.
To counter the risk to the treasury, certain protections have been negotiated. In all cases, the institution that receives the help has given up some measure of independent control of their future actions and decisions. The Federal Reserve has also received warrants to purchase strong equity positions, to own stock as high as 80%. This stock acquisition actually preempts and dilutes existing stock ownership. The losers here are existing stock holders.
Additionally, the loans have been secured by existing assets.
In the case of AIG, the government seems to be well positioned. The goal is to provide time for the very large and complex company to sell its assets in an orderly and manageable way. Given time, the restructuring of an industry giant can take place with minimal economic impact. It is the sudden crash that destabilizes national and global markets and economies.
The Treasury action gives AIG a two year period to conduct an orderly restructure and divestiture.
In the case of Fannie and Freddie, the government took preemptive action to maintain market stability. There seems to be more of a risk to tax payer money here. The future losses will depend on the actual performance of the housing market. The government has indicated that as much as $200 billion dollars would be available to purchase mortgage securities to maintain liquidity. When the government purchases these securities, they own the liability of any losses incurred.
To limit tax payer risk, the Treasury received warrants to purchase up to an 80% security position. It has gained control over the management of the agencies. The government will be repaid before any proceeds are paid to stock holders. The risk to the tax payer is still real, especially if the housing market continues to deteriorate.
These loans/investments are true bailouts, but they are worked out with arrangements that provide control over operations and security for the tax payer risk.
Please comment to add or to correct anything in this post.
Richard Smith
American Acceptance Mortgage, Inc
Toll Free 888-474-9920 Cell 423-280-0345
Home financing in Tennessee, Georgia, and Alabama.
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rsmith@aamonline.com
