Will The Fed Bail? The Doubt is Gone Forever

Regulators love pretending they might not intervene with magic money and other powerful tools when economies wobble. That little trick is no longer believeable.

Photo: Stefan Fussan, Creative Commons

Book review: Limitless, Jeanna Smialek, 2023; Manias, Panics and Crashes, Robert Aliber and Charles Kindleberger, 2015; and The Courage to Act, Ben Bernanke, 2015.

The publishers of the classic Manias, Panics and Crashes, now on its seventh edition, still haven’t added “Bailouts” to the title. Maybe they thought it would be redundant.

In March the government rescued uninsured depositors at the collapsing Silicon Valley Bank and Signature Bank. Then it lowered collateral standards for emergency loans to other shaky banks. Then it more or less promised to declare even tiny banks too big to fail.

Historians can’t keep up. Jeanna Smialek’s Limitless: The Federal Reserve Takes on a New Age of Crisis, came out only a few weeks ago but of course is silent on SVB. She’s writing about the last crisis, when frantic measures saved the economy from Covid. Chapter titles include “The Day the Fed Changed” and “Racing Across Red Lines.”

That was three years ago. Now the Fed and other regulators are changing again. New red lines are turning green.

In May 2008 then-Fed Chairman Ben Bernanke warned against frequent and prompt regulator rescues. This was right before the biggest financial collapse since the Depression.

Central banks should not be “too quick” to save troubled lenders, he said. Otherwise financiers become reckless, knowing a backup exists. The term is “moral hazard,” a concept best known to insurance companies paying claims for arsons and bungee jumping accidents.

Economists like Bernanke know the best way to predict behavior is to pay attention to what people do, not what they say. The revealed preference of central bankers faced with financial squalls is by now obvious: man the pumps.

Bernanke saved the economy in 2008 and 2009, using trillions of dollars of the Fed’s infinite capital to overpay dumb lenders for subprime mortgages and other toxic assets. Last December he went to Stockholm to accept the Sveriges Riksbank Prize in Memory of Alfred Nobel for Rewarding Moral Hazard. (Yes, he got a Nobel. No, that’s not what it was called.)

Charles Kindleberger, an economic historian and original author of Manias, Panics and Crashes, gave away the central banker game 45 years ago.

“Always come to the rescue” in a financial meltdown, he wrote in the book’s first edition. “But always leave it uncertain whether the rescue will arrive on time or at all.” “A neat trick,” he called it.¹

The uncertainty is over. More-recent editions of the book say, “eventually always come to the rescue.” But the jig is up.

Limitless is the right name for a book about people who create trillions of dollars in electronic credits (“money”) with a few keystrokes. Read together with Manias and The Courage to Act, Bernanke’s 2015 memoir of the subprime mortgage circus, Limitless gives a clear view of the Fed’s growing power and a good idea of what to expect in the next crisis, in scale if not in detail.

“Central banking is one big experiment, and people who claim to have it all figured out are oversimplifying,” Smialek writes. Her well-supported and slightly foreboding thesis: “Fed officials are ordinary people who control increasingly potent tools.”²

The takeaway, of course, is that by building a floor under the markets the Fed has traded the risk of deflationary depression for the increasing likelihood of long-term inflation, of which we’re already getting a taste.

The Fed has also permanently boosted stock-market valuations. Long-term investors are happy to own the S&P 500 at 20 times earnings when they know crashes are likely to be relatively brief.

Kindleberger, an MIT professor, was starved for recent material when the first edition of Manias came out in 1978. He had to make the most of the South Sea Bubble and the Depression. Since the 1930s there had been shotgun bank marriages, surging inflation and stock and bond storms — but no systemic financial breakdown.

Later editions covered the 1980s sovereign debt crisis and savings and loan debacle and the 1987s stock crash. The 1990s dotcom bubble, described in the fifth edition, was a fabulous, full-blown, Kindlebergerian mania.

But for the Fed these episodes, painful and stressful as they were, amounted more or less to business as usual. It eased monetary conditions when necessary and coordinated with Treasury and other central banks on hotspots. The dotcom companies had been financed by equity, not debt, leaving banks untouched when they imploded.

For six decades the Fed had been the bankers’ bank, as its founders intended, lending only to banks in their role as financiers of the wider economy. Even many financial insiders probably assumed this was all it could do.

But inside the Federal Reserve Act, as amended in the worst year of the Depression, was a sleeper clause. Section 13(3) said that, under “unusual and exigent circumstances” the Fed could make collateralized loans to “any participant in any program or facility with broad-based eligibility,” not just banks.

In 2008, during the subprime mortgage meltdown, the Fed invoked 13(3) for the first time since the Depression. By accepting “private-label” mortgage securities as collateral, not just Fannie Mae and Freddie Mac packages, it was backstopping investments not guaranteed by the US government.

“We’re crossing certain lines,” Bernanke wrote to colleagues. “We’re doing things we haven’t done before.” They announced the move "in technical financial language" that didn't mention extraordinary levers untouched since the time of FDR, Bernanke writes. He says he didn't want to panic markets.³

“Doing things we haven’t done before” is the Fed’s 21st century motto.

Its 2008 13(3) loans saved Bear Stearns and AIG, both dying of mortgage poison. Neither was a chartered bank. The Fed bailed out AIG again under 13(3) by buying mortgage securities that AIG owned and debt obligations that AIG had insured.⁴

Then it crossed another line. Normally the Fed helps a cooling economy by lowering short-term interest rates. But in late 2008 rates were already zero. Financial pundits had warned about this. The Fed had finally “run out of ammunition.” The economy was still collapsing.

What to do? Long-term rates! Using newly conjured money ultimately adding up to $4.5 trillion, according to Manias, the Fed bought up Treasury notes and bonds, Fannie and Freddie debt and mortgage-backed securities. The “quantitative easing” lowered long-term borrowing costs for everybody, including, incidentally or not, American taxpayers financing bigger and bigger budget deficits.

“Quantitative Easing: The End of Orthodoxy,” Bernanke named one of his chapters.

On March 23, 2020, as Covid-19 spread, the Fed announced it had a “full range of tools” ready to save the economy and listed some. Not just the old tools, including QE, bigger and faster. The central bank was also “crossing nearly every barrier it had left standing after the 2008 crisis,” Smialek writes.

New initiatives included purchases of corporate and municipal bonds and lending directly to states and cities. This was less than a year after Fed Chairman Jerome Powell had said, “We don’t have the authority, I don’t believe, to lend to state and local governments.”

There was more. Amazingly, for an institution that had always cared about credit quality, the Fed started buying exchange-traded junk-bond funds, propping up corporate CEOs who had overborrowed to finance stock buybacks and their own pay packages.

Part of the central-banker “leave it uncertain” schtick is to talk about interventions as being extraordinary and brief. When regulators started invoking 13(3) in 2008 they said the measures were “temporary and precautionary.”⁵ One of Powell’s jobs in 2022 was “reestablish the Fed’s boundaries,” Smialek writes.

But one lesson from these books is that the boundaries are flexible but not especially elastic. Heterodoxy in one crisis is orthodoxy during the next. Measures like QE last longer and return sooner than you expect.

Limitless powers tend to be used. And there will be more and more reasons to use them.

Regulators now have to worry about electronic bank runs like the one at Silicon Valley Bank. They’ve basically guaranteed all deposits at too-big-to fail banks such as Citi and JP Morgan Chase while theoretically exposing accounts over $250,000 at smaller banks to risk. Money has been cascading from the latter to the former.

Again there is perennial talk of better regulation, better examiners blah blah. Good regulation is essential. Deposit insurance since the 1930s and higher capital requirements since the 2000s have surely prevented some grief.

But it’s always something. SVB examiners were so focused on 2008-style credit risk that they overlooked the interest rate risk that cratered the bank’s bond portfolio.

It took the FDIC just a day after SVB’s seizure to say it would protect “uninsured” deposits. That’s not uncertainty.

Letting Lehman Brothers fail in 2008 is widely viewed as a terrible mistake that should never be repeated.

“Economic history would have been different if the US government had become the dominant shareholder in Lehman Brothers and had kept it open,” writes Robert Aliber, who took over updating Manias after Kindleberger died in 2003.⁶

Bailouts are increasingly seen as triggers for virtuous cycles rather than market distortions. The Fed can’t lend to anybody without good collateral. But regulators have learned that intervention can fluff up the collateral, giving them room to intervene again.

The Fed’s initial $85 billion loan to AIG stabilized markets and supported the price of iffy AIG assets. That paved the way for more financing including $40 billion in AIG preferred stock bought by Treasury.

“There was some circularity here,” Bernanke says coyly.⁷

A frozen Congress is another reason for the Fed to flex. Bernanke and Powell dispatched hundreds of billions of dollars in almost an instant while the legislature can’t even pass a budget.

The Fed’s tools announced in March 2020 included something called the Main Street Business Lending Program. What was it? How would it work? Nobody knew. But Congress had failed to provide a hoped-for plan to aid middle-sized and small businesses. So the Fed “simply announced that a rescue was coming,” Smialek writes.⁸

The Fed now owns some $2.3 trillion in US Treasury debt, helping to finance perennial budget deficits that Congress has done little to address. This will continue.

Three years ago Eric Rosengren, then-head of the Federal Reserve Bank of Boston, said that in certain situations the Fed should be able “to purchase a broader range of securities or assets” than it traditionally has. He referred to an old paper suggesting the Fed could buy long-term bonds (which it subsequently did for QE) as well as gold or even land.

The Fed has already bought junk-bond ETFs. ETFs are good for supporting markets because inflows of newly created money prompt managers to buy the underlying assets tracked by the fund.

Don’t be surprised if someday the Fed buys stock ETFs in a meltdown. The Bank of Japan, a pioneer in QE, has been buying stocks for years and is one of the biggest shareholders in Japan’s Topix index.

Fed officials will tell you that the law, the duty to protect taxpayers and the danger of promoting moral hazard all limit what they can do.

"Laws can be stretched," Smialek writes. “Often when the Fed says it cannot do something, what it really means is that it does not want to.”⁹ Until it does.

The Dodd-Frank Act of 2010 supposedly removes 13(3) authority for the Fed to rescue particular entities, giving authorities instead the ability to seize and liquidate failing firms in a kind of hothouse bankruptcy. But for broad interventions, the “unusual and exigent” 13)3) wildcard remains.

During the crisis Barney Frank was the ranking Democrat on the House Financial Services Committee in 2008. That should have given him some vague idea of the Fed’s wherewithal.

He asked where Bernanke was going to get $85 billion to lend to AIG. “Barney looked stunned,” Bernanke writes. “He didn’t see why the Fed should have that amount of money at its disposal.”¹⁰

Bernanke explained 13(3). The Fed is never out of ammunition.

1. Robert Z. Aliber and Charles P. Kindleberger, Manias, Panics and Crashes: A History of Financial Crises, p. 35.

2. Smialek, Jeanna, Limitless: The Federal Reserve Takes on a New Age of Crisis, p. 10.

3. Bernanke, The Courage to Act: A Memoir of a Crisis and Its Aftermath, pp. 208-209.

4. Bernanke, pp. 365-367.

5. Bernanke, p. 234.

6. Aliber and Kindleberger, p. 325.

7. Bernanke, p. 282.

8. Smialek, p. 187.

9. Smialek, p. 209.

10. Bernanke, p. 285.