On the Federal Reserve and stupid, stupid people

With all the banter out about the Federal Reserve and their activities during the credit crisis, it seems like a good time to maybe discuss the fact that the Federal Reserve actually did what it was intended to do. It’s primary mission as the central bank of the United States is to make sure that banks have capital during a crisis.

Shocking, I know, especially with all the chest banging from both the right and the left about ‘bailing out the banks’. It’s rare that you see FireDogLake, DailyKos and RedState all bitching and moaning about anything in unison. But that’s happening and it’s time for someone to tell them to shut the hell up, because none of them know what the hell they’re talking about.

Let’s take a moment to pull what the Fed did off the table. For all the people yelling and screaming, let’s look at what would have happened without the intervention of the Fed. Call it a What If… for those who like to engage in puerile doomsday fantasies.

First off, every major bank in this country would have been insolvent and been taken over by the FDIC. There just is no other way the crisis would have gone since liquidity vanished in days. Now the taxpayers own the complete liabilities of the banks and the majority of the deposits in this country are now controlled by the US Government. But that’s just the start since all the investment banks would be gone and with them the ability to underwrite securities and sell and market US Treasury debt. This is fun because it effectively eliminates the securitization market which means no car loans, no credit cards and no home loans. Not that it would matter much anyway, since the loss of confidence in the US (which occurred in the real world when Lehman was forced into bankruptcy… in fact, that event triggered the actions of the Fed and Treasury) that would result from all this would keep investors out of US securities even if they had been issued. And with that, the stock market would likely have fallen below 2,000, a level not seen since the 80’s and most American pension funds would be insolvent (not to mention most 401k accounts and IRA’s and just for grins, insurers).

The elimination of lending would have effectively collapsed every homebuilder, developer and company that made a good or sold a good that depended on credit either for the operation of the company, or the sales channel or the consumer. Which means car dealerships would have been forced to shut down and automakers would have closed overnight, not to mention retailers, restaurants and basically every business that is dependent in one way or another on credit. Oh, sure, you had small banks and credit unions but they too would have felt the pinch. In this scenario, unemployment would have rapidly hit 30-40%. For those of you concerned about the debt, imagine what happens when tax receipts fall precipitously at the same time unemployment claims rise dramatically. Oh, and of course, there is also the debt we have to take on to fix the banks.

Not that it would matter since the US would have problems selling debt as we’d be seen as a poor risk as investors shifted to the euro and yen given that it’s clear the US isn’t functioning in any meaningful way.

Now that we’ve done the What If… for the disaster porn aficionados, let’s take a look at what reserve banking is all about. Let’s say you and I both own banks. While you’ve been very aggressive with your lending, I’ve been more conservative. As a result, you’re seeing some credit losses on our loan portfolio while I’m not. Rumors begin to circulate that your losses are bad and your depositors begin to pull out money. Then you come to me, asking for help, which I’m happy to give you since in reality your losses are not fatal and you’ll recover. However, my depositors start hearing about my lending to you and they start to pull money from me. Suddenly, it’s a run and both of us are now at risk. First, your bank folds up. I hold on a little longer but soon I too have to close the doors to withdrawals. The community we service then suffers a rather severe economic downtown because the credit we provided no longer is available.

What could have saved our banks was a central reserve bank that was large enough to step in and lend us money so that we could continue our lending and making depositors whole. This is called ‘lending into a run’ and you do it because runs are all about panic. When everyone gets their money without problems, they calm down, return to rational thinking and put the money back. In many instances, just having a public announcement from a large enough reserve bank (like the Federal Reserve) that they are going to back up the bank is enough to break the panic.

That’s what the Federal Reserve was set up to do. Prior to it, you had a number of players in banking, principally JP Morgan, would step in and stop panics or,failing that, try to constrict their duration and spread. Prior to the Federal Reserve and the regulation of the 1930’s this country went through depressions, as often as recessions, that were in many cases worse that what we now call the Great Depression. Bank runs were pretty common and there needed to be a central authority, independent of politics but with some government oversight, that could step in and act as the bank of last resort. It’s fairly well understood at this point that the failure of the Federal Reserve to act in just this capacity in the initial stages of the Great Depression made the downturn far worse. Fully cognizant of that fact, the Federal Reserve this time around acted and as a result the entire banking system didn’t collapse and we didn’t even have to have a three day bank holiday.

Much has been made of the amount the Fed said it would outlay to stop what was essentially a global crisis. That totaled close to $14 trillion. Only the uneducated would even act like anything approaching that was at risk. Frankly, that was a number created to make sure the world knew the Fed was going to do what it needed to do to break the panic. The actual money out the door was close to $5 trillion to provide liquidity and now less than $2 trillion is outstanding. Sounds like an incredible number until you realize that close to 75% of it is nothing more than mortgage debt and GSE debt all of which is paying. Those credits were purchased to make sure people would actually buy AND sell homes in the US.

The problem, as far as I can tell, is that the complexity of all this is getting to people. At the end of the day, I’ve read so much garbage during this crisis that it’s really making the question the education levels of people on both sides of the spectrum. At the base, this was about investment colluding with ratings agencies to get a bunch of CCC securities rated AAA. When those securities started performing like trip C’s instead of trip A’s, the market froze up. Then people started to question all ratings on everything and no one wanted to lend because, OMG! they might have this shit on their balance sheets, too! That’s a panic, kids, caused by nothing more than basic fraud. And yes, the investment banks should pay VERY handsomely for all this.

However, those of you out there furiously wishing everything had gone up in flames are absolutely delusional and should seek some professional help. As The Mayor recently commented to me when I was discussing this, y’all shouldn’t assume the world will be more like Eden than Road Warrior if only things collapsed one afternoon.

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