December 13 2007: 4:24 AM EST
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Why the Fed bailout might not work

The announced plan to make credit markets more liquid could end up having the opposite effect.

By Peter Eavis, senior writer

NEW YORK (Fortune) -- The Federal Reserve's latest move to make credit markets more liquid could deepen problems in the banking system and actually cause the markets to be even more illiquid.

Wednesday, the Fed, along with other central banks, announced a plan that is designed to enable banks to borrow money directly from the Fed at below-market rates. This will allow a wider range of banks to access Fed credit, and simultaneously allow them to submit a broader range of collateral to the Fed when taking out those loans.

Why do this now? The Fed explained in a release Wednesday: "This facility could help promote the efficient dissemination of liquidity when the unsecured interbank markets are under stress." In layman's terms this means that rates on loans between banks - measured by something called the London Interbank Offered Rate, or Libor - are too high for the Fed's tastes, so it is now prepared to itself lend to banks at much lower rates.

Before this move, banks could borrow directly from the Fed through the so-called discount window, at 4.75 percent. The key Federal funds rate is lower, at 4.25%, but that is open to a narrower range of financial institutions and accepts a narrower range of collateral than the discount window. The new program - called the Term Auction Facility (TAF) - will auction funds to banks at rates very close to the lower Fed funds rate. The first TAF auction, for $20 billion, is scheduled to begin on Dec. 17.

What could go wrong with such an approach? Surely, it makes sense for banks to be lending to each other at lower rates, since that can spark more lending across the whole financial system. But Libor is a market rate, ultimately reflecting banks' views on each other's creditworthiness. Indeed, at 5.06% before news of the TAF was released by the Fed, Libor was considerably higher than the Fed funds rate, reflecting banks' caution about each other. But maybe the widened spread between Libor and the Fed funds rate is an inescapable product of the times. Given the credit problems U.S. banks are facing, they are naturally wary of each other. Maybe the Fed thinks banks are being overcautious, so the TAF is its way of bypassing what it sees as unwarranted skittishness.

But it makes more sense to believe the banks' view of each other than the Fed's. Banks do business with banks each day, so they're far more likely to have a good handle on each other's balance sheet problems. Moreover, as theoretically profit-making entities, private banks have to carefully assess the creditworthiness of the borrowers, which means they have far more incentive to do their homework than the Federal Reserve.

The potentially dangerous aspect of the TAF is that it will allow banks with problems to borrow their way out of trouble, rather than by taking measures like issuing large amounts of stock to bolster their balance sheets. Struggling banks are struggling chiefly because they were mismanaged and wrote too many risky loans when credit was cheap. The TAF potentially gives mismanaged banks even more cheap credit, which will delay a much-needed restructuring of the banking sector. Nervousness about banks could then deepen, leading to even fewer loans being made.

One of the big lessons of the credit crunch is that overly cheap credit causes massive harm to the economy in the long run. The TAF suggests that the Fed still hasn't learned that.  To top of page