When it looked as if the global economy was burning down in March of last year, the Federal Reserve unleashed a fire hose of emergency lending. Nearly a year later, we still don’t know how much risk the Fed has taken on through its lending facilities. These 15 facilities are an alphabet soup, dense and unpalatable except to the most zealous Fed watchers. Worse, they make loans to risky borrowers, sometimes lending against risky collateral or no collateral at all.
On October 3, 2020, I filed a records request with the Fed under the Freedom of Information Act (FOIA), with the goal of understanding the Fed’s own risk management in making these loans. I wanted greater transparency as to why the Fed expects that each facility “will not result in losses,” as its board of governors stated to Congress in a periodic report. Four months later, the Fed has failed to provide any records.
For example, the Municipal Lending Facility (MLF) makes direct loans to state and local governments. The Fed’s documents show that, in practice, it has lent only to the state of Illinois and the New York Metropolitan Transportation Authority (MTA). Illinois bonds have a near-junk credit rating and a deteriorating outlook. The financial position of the MTA is “dire,” as recently described by New York’s comptroller, and the Fed extended these loans at extremely low interest rates without demanding collateral.
Another example, the Primary Dealer Credit Facility (PDCF), makes loans to large investment banks that transact with the New York Fed. These loans can be secured by collateral that is highly risky and difficult to value. Think equity and corporate debt, as well as structured products such as commercial mortgage-backed securities, collateralized loan obligations, and collateralized debt obligations. While structured products require AAA-ratings to be eligible, it’s only been a decade since the failure of mis-rated structured products caused a financial panic. Even equity and corporate debt can significantly decline in value. Yet for these risks, the Fed only charges an interest rate of 0.25 percent.
The credit risk of these investments is ultimately backstopped by the U.S. Treasury. In fairness to Fed officials, they stood up these 15 facilities with the authorization of the Treasury secretary, Congress, and the president. Fed officials transparently acknowledge their credit risk and Treasury backstop.
The law also acknowledges the credit risk of emergency loans. Specifically, Section 13(3) of the Federal Reserve Act provides the Fed with its emergency lending powers. “In unusual and exigent circumstances,” the Fed may engage in “broad-based” lending “for the purpose of providing liquidity to the financial system.” Section 13(3) makes clear that the purpose of emergency lending must not be “to aid a failing financial company.” The lending must be secured by collateral “sufficient to protect taxpayers from losses . . . consistent with sound risk management practices.”
Congress included these important restrictions in the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act. They did so in response to the Fed’s controversial use of 13(3) during the financial crisis of 2007–09. The Fed invoked the then-obscure provision to lend to nonbank financial firms that it considered “too big to fail” — AIG, Bear Sterns, Citibank, and Bank of America. As in 2020, the Fed also established facilities to provide liquidity to large investment firms and to markets for commercial paper and asset-backed securities. The Fed is normally prohibited from making these kinds of loans. Traditional lending through the discount window is limited to banks that are closely supervised and regulated by the Fed, while traditional open-market operations are limited to high-quality assets, principally Treasuries and agency mortgage-backed securities.
At its peak in November 2008, lending under 13(3) reached $710 billion. Despite the controversy, the Fed earned profits of more than $30 billion and did not suffer losses on any transactions. The records I requested would shed light on the likelihood of keeping the winning streak going.
Understandably, the Fed has a culture of caution around the publication of sensitive records. During the Great Depression, the unexpected publication of a list of borrowers from the Reconstruction Finance Corporation, which at the time served as an emergency lender, sparked a panic among depositors who questioned the banks’ solvency. Ever since, the resulting “stigma” of emergency borrowing has made these programs less effective. But if the Fed is concerned about the harms of disclosures, it can indicate as much in response to my FOIA request. Their failure to respond indicates that officials may be concerned that the publication of negative information could lead to a reduction of the Fed’s discretion.
In the past, Fed chair Jay Powell has opposed reductions to the Fed’s discretion under 13(3). In his words, the Fed needs to “be able to respond flexibly and nimbly to future emergencies.” Fair point. Tolstoy once wrote, “All happy families are alike; each unhappy family is unhappy in its own way.” Applying his principle here, it might be unwise to predetermine the Fed’s response to future crises, which are all unique. Even so, the Fed is still required to protect the taxpayer from losses and answer FOIA requests.
From the information available, I believe the Fed should charge penalty rates to reduce moral hazard and properly compensate taxpayers. The practice of charging penalty rates, famously advocated by Walter Bagehot in his 1873 book Lombard Street: A Description of the Money Market, is supported by the history of hundreds of years of financial crises. I also believe that the MLF and PDCF cannot be broad-based, as required by law, if in practice their loans are only to politically favored governments and investment banks. Broad-based emergency lending is necessary to insulate the Fed from short-term political pressures and threats to its independence.
This month, Powell will testify to Congress about the Fed’s semiannual Monetary Policy Report. All members of Congress should ask Chairman Powell for greater transparency. What risks has the Fed taken on public credit, and why won’t the Fed answer a FOIA request about those risks?