Can the Fed's new tools fix our ailing economy?

Yes

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by Dave Coker

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A question has been raised about The Fed's ability to fix the current state of our economy. Specifically, it has been asked can The Fed's "new tools" suffice to resolve the problems underlying our economy.

This paper will argue that yes, The Fed will indeed be able to overcome our current problems. As part of this argument, we will first identify what problems have arisen and what problems The Fed has focused its attention on. We will next outline tools already at the disposal of The Fed and briefly illustrate their functioning. Next, we will identify new tools that have been deployed and describe their use.

Finally, we will outline the scale of the problems presently facing The United States and illustrate why the new tools - when used together with existing tools - will help The Fed fix our economy.

CURRENT PROBLEMS FACING THE UNITED STATES

The current malaise regarding the performance of our economy seems to have had its origins in the ongoing housing crisis which began Q3 of 2007.

The housing crisis is the aftermath of a speculative bubble focused on real estate in The United States. Much like the so-called "dot com" speculative bubble which saw unrealistic share values, prices for real estate diverged markedly from fair value. Initiated by low interest rates and encouraged by a light regulatory environment, unsound lending practices took hold and flourished, fueled on by the greed of participants at all levels. The bubble grew and grew but as it did The Federal Reserve raised interest rates multiple times over a three year period, from a 2003 low of 1% to a 2006 high of 5.25%, in an attempt to bring it back under control.

It is a fact that asset bubbles never slowly deflate, rather they burst and sometimes the fallout is widespread.

Amid the backdrop of a bursting housing bubble, additional questions about the state of our economy have been raised by sharp increases in commodity prices at the same time the US Dollar has plunged and economic growth in America - as well as most of the G7 - slows. Others symptoms include rapid inflationary increases at the same time credit lines being offered by banks to the public are being sharply decreased or withdrawn totally.

The Fed has identified the sub-prime crisis and the withdrawal or reduction of banking credit lines as their number one problems at this time.

All things considered, it is easy to see why the mood of the nation is sour. But the United States has experienced similar problems in the past. Not precisely identical, but the broad themes - recession, increasing commodity prices, a plunging housing market, the weak dollar, driving inflation - have been seen before. And the United State has prevailed. Just as it shall prevail this time.

And how have these successes been realized? By Central Bankers, using a time tested inventory of tools. Some of these tools have names familiar to all households, while others are very obscure, perhaps known only to bankers. Let's look at some of the existing tools that can be wielded to deal with the current problem.

EXISTING TOOLS

Central Bankers traditionally have employed many tools to manage the economy. While these tools vary in terms of their effects, they all change the money supply - and thus the broader economy - in some way. The relationship between money and the economy is similar to that of gasoline and a car; as the supply of gas increases so does the distance that car can travel. Adding money to the economy causes it to expand. Similarly, the economy contracts when money is removed.

Existing tools include:

1) Interest rates

Interest rates are immediately familiar to everyone because they impact all of us. In the United States Central Bankers set what is known as "The Fed funds rate", with market forces controlling the wider scope of interest rates such as rates paid on loans or rates received on savings deposits.

Interest rates are but one mechanism for The Fed to control the money supply.

2) Reserve requirements

As part of normal business, banks accept deposits from savers and pay interest to borrowers. Thus, deposited funds can reenter the monetary system as a result of the loan process.

However not all funds deposited at bank may be lent out. In order to insure the stability each institution as well as of the financial system as a whole, regulators demand banks hold a fixed percentage of their assets - a "reserve requirement" - in liquid form. This insures that when savers wish to withdraw funds, their money will be available regardless of the banks loan activities. By increasing or decreasing this percentage - - the money supply can be indirectly controlled.

3) Capital requirements

By law banks must have minimal amount of capital; that is, a specific amount of money underlying the institution. This capital is intended to insure stability of bank as an ongoing concern. Note that this money is above and beyond any sums entrusted to the bank by customers. This is the banks own money, and by increasing or decreasing this minimum amount - known in the business as a "capital requirement" - the money supply can be indirectly controlled.

4) Open Market Operations

A very direct mechanism for influencing the money supply, Central Bankers inject or remove funds by purchasing securities from the open market. This trading activity is known as "Open Market Operations", generally involve the purchase or sale of US Government Securities. Open Market Operations are very common, and sometimes take place in a coordinated manner. For example, many G7 Central Bankers have worked together in the past to attempt to control the US Dollar or the appreciation of the Japanese Yen.

5) The Discount Window

Banks having short term need of funds can approach The Fed for a loan; this lending facility is known as "The Discount Window", and it has been in use since the early twentieth century.

But borrowing institution must pledge collateral - usually Government Securities or high quality corporate bonds - and the term of the loan is typically for one day only.

6) Lender of last resort

While not a traditional tool in the sense that it's commonly used, The Federal Reserve currently and has always stood ready as "lender of last resort", operating in the best interests of the American economy by insuring that financial institutions always have access to funds under any circumstances.

In rare circumstances the Federal Reserve may also compel the sale or liquidation of struggling institutions.

But some fear that existing tools - although tried and true - won't be enough. And in response to these concerns, in an attempt to calm the markets and help assuage fears of all market participants, The Fed has deployed some rather powerful new tools.

NEW TOOLS

Ben Bernanke felt many of the current tools were too limited, particularly in terms of the collateral accepted for loans, therefore The Fed deployed the new tools described in this section.

1) Term Discount Window Program

Like The Discount Window, the "Term Discount Window Program" or TDWP also offers collateralized loans to borrowing banks. Like The Discount Window, US Government Securities or high quality corporate bonds are accepted as collateral, but unlike The Discount Window, the TDWP allows institutions to borrow for up to thirty days. Even so, borrowing institutions must roll over, or renew loans obtained under the TDWP on a daily or weekly basis.

Via the TDWP The Fed is helping to expand the money supply, and injecting liquidity into the system.

2) The Term Auction Facility

The Term Auction Facility, or TAF, is very similar to the TDWP but markedly broadens the collateral that may be used. Controversially, the TAF allows banks to pledge Mortgage Backed Securities - even those backed by sub-prime loans - as collateral for loans.

The TAF adds to the money supply, injecting liquidity.

3) The Term Securities Lending Facility

The Term Securities Lending Facility, or TSLF is very similar to the TAF, however it is directed at a subset of banks known as "Primary Dealers", or institutions who deal directly with The Fed as part of regular treasury auctions.

Via the TSLF The Fed is specifically addressing a segment of the banking community to help increase the money supply and add liquidity.

As we have seen, The Fed under Ben Bernanke also has deployed several new, somewhat controversial tools to help control the sub-prime crisis. They are intended to be used as compliments to existing tools.

But lets put all of this into some perspective. Just how serious is the sub-prime crisis? Will the deflation of this speculative bubble lead to a deep recession or even depression as some commentators predict? And can The Fed really help?

PUTTING IT ALL INTO CONTEXT

As of 2005 the Bank for International Settlements (BIS) sized the US Mortgage Market at roughly $8 trillion. While its safe to conclude the market grew in size up until the correction, lets work with this figure as is so our analysis will have conservative results.

Since the speculative bubble collapsed, many news articles have illustrated the write down of assets by banks operating in the sub prime sector. Figures as large as $300 billion have been reported as evidence of serious, significant problems in the US economy.

But under the portions of Generally Accepted Accounting Principles (aka, GAAP) applying to the Impairment of Long Lived Assets, when banks write down loans, the assets in question are still carried on the balance sheet, just at a - perhaps sharply - reduced value.

The loans are not written off, removed from the banks balance sheets, but instead are revalued.

So considering write downs of $300 billion, we see that perhaps 3.75% (300 billion divided by eight trillion) of the total outstanding mortgage debt in the United States is at risk of being revalued. Not lost, as would be the case in a write off, but simply having the value changed as happens with a write down. This isn't exactly the stuff economic depressions are made of, not when this is compared to widespread bank failures of 1929.

But lets take this further. Let's assume that the entire sub-prime sector, a full ONE TRILLION of the nations outstanding mortgage debt will be written down. What might appear to be a pessimistic view is indeed consistent with the scale of the recapitalization going on presently in banking (e.g., rights issues, secondary offerings, etc) as well as the estimates of some banking analysts.

So then we'd have 12.5% (one eighth) of the outstanding mortgage debt being written down. Ok then, now we're getting up there. To use an accounting phrase, this would indeed be a material difference, to be sure, but still not time to panic.

There is a fundamental difference between write downs and write offs, one that was mentioned before. The banks aren't writing off - eliminating - one trillion dollars worth of their debt. They are writing it down, marking it's value DOWN.

That Mansion which previously sold for one million dollars? Now the market - and the bank - values it at 50% less, lets call it five hundred million. So they are changing the value of the property the mortgage was written against.

So its clear we're talking about reductions and not total elimination of mortgage debt. Although there will be some complete losses.

CONCLUSION

But lets step back from the details for a moment, and take a long term view. This is NOT the first time that The United States housing market has crashed. And The Fed has a wide range of existing tools to deal with housing crashes, tools that have seen the test of time.

Even so, The Fed has deployed several new, very powerful weapons - Term Discount Window Program, The Term Auction Facility and The Term Securities Lending Facility - to help bring order to the markets, calm nerves and provide liquidity. Illustrating the determination of The Fed, these tools have been deployed specifically to help with this crisis. If necessary, The Fed will augment their use or even deploy additional tools.

The most powerful weapon The Fed has deployed - the newest tool available to it - is it's determination and flexibility to resolve this problem.

Sir John Templeton once said "The four most dangerous words in investing are 'This time it's different.'.

Those who argue The Fed can't prevail over current US economic problems are making this argument, that these are somehow different times.

But the US housing market has collapsed before. The Fed has a wide array of tools - both old and new - that can be brought to bear on this problem.

The Fed's new tools - used along with the existing tools - will fix the nations economy.

Just as has been done many, many times before.

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