The Fed and Crony Capitalism

In an attempt to stop the rot on Wall Street, the Federal Reserve recently granted special borrowing rights to Wall Street’s largest investment banks. That decision smells of special dealing for special interests. The decision subsidizes these big powerful firms, thereby distorting financial markets in their favor. Behind the decision lies the problem of excessive representation of Wall Street interests within the Fed.

The Fed's response to the crisis, combined with its earlier massive policy failure to address the housing price bubble, raise grave questions about its independence and judgment. At this stage, Congress should launch formal hearings into the governance of the Fed, which has remained largely unchanged since the 1930s.

The subsidy to the big investment banks operates though the Fed’s new Primary Dealer Credit Facility (PDCF) that gives investment banks who deal in government bonds access to cheap Fed funds. As a result, the chosen few can borrow money from the Fed at the bargain basement interest rate of 2.5 percent, and all that is asked is borrowers post some form of investment-grade collateral.

This arrangement constitutes a massive subsidy, which would be large in normal times. However, it is especially large at a time of market uncertainty and liquidity shortage. While other investors are being forced by the liquidity crisis to sell assets at fire-sale prices, the Fed's investment bank friends are being given near-free government money to snap up assets on the cheap.

Wall Street’s investment banks have been quick to embrace the facility, and within four days borrowing reached $29 billion. Erin Callan, Chief Financial Officer of Lehman Brothers, enthusiastically declared the facility to be "incredibly attractive -- our ability to access that form of financing to do more business for clients is incredibly interesting."

Morgan Stanley Chief Financial Officer Colm Kelleher described the facility as being "there for normal business. It's not meant to be there as a last-recourse thing." A Goldman Sachs spokesman declared "we think the Fed window provides a good alternative to the secured funding markets and we welcome the initiative."

The new facility represents a complete break with the past. Previously, discount window borrowing from the Fed was restricted to regulated depository institutions, and access was always described as "a privilege and not a right." That meant deposit-taking banks could only get access to cover seasonal or unanticipated shortfalls of funds, and any borrowing had to be justified and was subject to regulatory disapproval -- so-called Federal Reserve 'frown' costs. Now, the Fed is apparently making loans available as a source of ordinary business finance for Wall Street’s unregulated investment banks.

This means the Fed is providing risk capital to the likes of Goldman Sachs at paltry interest rates that confer on them a significant subsidy. Moreover, the mere right of access enables them to borrow more cheaply from other lenders because of the back-stop reassurance provided by discount window access. It also establishes incentives for future excessive risk-taking.

These subsidies are a travesty. Goldman Sachs, Lehman Brothers, and Morgan Stanley are extraordinarily profitable companies. They have also been the drivers of the worst trends in the American economy over the past generation, pushing excessive CEO pay that has spread like a cancer throughout corporate America, even reaching into universities and non-profits. Additionally, they have pedaled the shareholder value paradigm that has pushed companies to emphasize short-term gain over long-term investment, and contributed to ripping up America's social contract. Meanwhile, their business model has promoted speculation that is behind repeated asset and commodity price bubbles.

Subsidizing these firms is an insult to Main Street. Many families are losing their homes as part of the mortgage crisis. If they had access to 2.5 percent financing that would not be happening. Likewise, manufacturing firms are being forced to close because of lack of affordable capital, which is destroying jobs and the economic foundation of communities.

The Fed will claim it had to institute these measures to calm Wall Street. That is nonsense. The fair and economically efficient way for the Fed to deliver emergency liquidity to Wall Street is by an auction that is open to all financial firms, and in which participants supply good collateral. Those firms who need the funds most will bid the highest. That way, taxpayers get properly paid for their support, and the funds go to those who need them most.

Geologists say they learn the most from extreme events like earthquakes that reveal the reality of the earth's crust. For the past twenty-five years, critics of the Fed have been dismissed, and the Fed's high standing has blinded the reality of its revolving door with Wall Street and its class-based conduct of policy. Now, the Fed’s response to Wall Street’s panic has revealed the reality of its crony capitalist world. That provides an opening for long-needed reform.