How the Fed and the Treasury are jointly strategizing

BY PRASHANT REDDY

Last week the President insisted that there are "glimmers of hope" in the economy, and that he has acted with extraordinary measures in these extraordinary times. While the financial system is unfortunately still shaky at best, it is true that the Obama administration has acted with unprecedented vigor in committing trillions of dollars to economic programs.

However, it has had a difficult time explaining to the average American how spending such large quantities of money will improve the economy, or exactly what the key strategies that the Federal Reserve and the Treasury Department are employing to re-stabilize the financial system–without which the economy can get back on track–actually are. In fact, they can be broken down into three clear strategies: 1) provide short-term lending, 2) extend credit to targeted markets, and 3) assist banks in dumping "toxic assets."

These plans are the brainchild of a subtle but powerful relationship between the Federal Reserve and the Treasury Department. On a day-to-day basis, the Treasury, whose primary goal is to fund the operation of the federal government at minimal cost to the taxpayer, issues bonds in which the Fed is a major purchaser. The Fed also conducts its own auctions to issue bonds on behalf of the Treasury. Meanwhile, the Fed’s primary responsibility is to maintain the stability of the economy and the value of America’s currency, which it does primarily by adjusting interest rates.

In this more recent period, however, the Treasury and the Fed have been cooperating on major initiatives to intervene in the credit markets. Though they each retain their independent missions, theyhave been combining their lending powers to increase credit at a level of cooperation not seen for many decades.

Strategy 1: Providing short-term lending

A modern bank lends money to borrowers and finances that lending through bank deposits or loans. In the "credit crunch" beginning in late 2008, banks could not borrow money in the credit markets, which meant that they could not lend to businesses and individuals. To remedy this, the Fed opened low interest credit lines to healthy financial institutions for short-term periods. According to Fed chief Ben Bernanke, this falls in line with the Fed’s responsibility to "serve as a lender of last resort to financial institutions" to "try to calm financial crises." The Treasury complemented the Fed’s emergency lending programs with its own stabilization program, the Troubled Asset Relief Program (TARP). Regardless of TARP’s merits, the initiative indicates that Treasury played a crisis management role as well. Specifically, the Treasury used $350 billion of the $700 billion allocated to TARP to improve banks’ financial positions by purchasing equity shares in the banks via the stock market.

Strategy 2: Extending credit to target markets

The Fed and Treasury are also aiming to unfreeze certain vital credit markets to increase lending to the average consumer. To this end, the Treasury created the Term Asset-Backed Securities Loan Facility (TALF) which essentially authorized the Fed to print $200 billion to insure debt held by consumers. Thus, if a loan was issued to a consumer and the consumer defaulted, the lender would be able to recoup the loss. The goal of the joint Treasury-Fed TALF program was to immediately guarantee crucial markets for student loans, auto loans, and credit cards.

The Fed is also taking supplementary action in the housing market to ensure that this market becomes stabilized and the infamous mortgage-backed-securities do not fall further in value. According to Bernanke, "Buying mortgage-related securities helps to drive down the interest rates that consumers pay on mortgages." Thus, the Fed has authorized Fannie Mae and Freddie Mac to purchase over $1 trillion in these securities.

Strategy 3: Helping banks dump toxic assets

The most thorny policy issue the Fed and Treasury face is how to assist financial institutions in off-loading substantially devalued assets, especially with regard to their holdings in mortgage-backed securities. The two actors are coordinating on a Financial Stabilization Plan (FSP) whose key objectives are to permanently unfreezing the credit markets and modify mortgages. The plan increases the TALF to $1 trillion, but it also creates a public-private toxic asset purchase program that is designed to use tax payer funds to subsidize the purchase of toxic assets.

Specifically, the public-private program allows for auctions of "toxic assets" in which the government, through the Fed and the Federal Deposit Insurance Corporation, insure a substantial portion of the risk associated with purchasing these toxic assets. Thus, if the purchased toxic asset gives a poor return, the purchaser will be compensated by the government. Moreover, if the asset turns out to yield good returns, the purchaser gets to keep the returns. The underlying principle is that the public good of stabilizing the financial system is worth more than any potential government losses.

Decades from now, the history books will chronicle how our government approached the problems we face. Just as the New Deal is synonymous with resolving the Great Depression, the package of policies implemented in this era by the Treasury and the Fed will be synonymous with the success or failure of the Obama Administration’s approach to this recession.

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