December 3, 2010 12:38 am

Sunlight shows cracks in crisis rescue story

Apparently, the Fed took on far more risk than most people realise, writes Frank Partnoy

It took two years, a hard-fought lawsuit, and an act of Congress, but finally on Wednesday, the Federal Reserve disclosed the details of its financial crisis lending programmes. The initial reactions were shock at the breadth of lending, particularly to foreign firms. But the details paint a bleaker, earlier, and even more disturbing picture. They also highlight new tensions over high-tech transparency, echoing the controversy of the WikiLeaks cables, unveiled just days earlier.

The Fed uploaded to its website several giant spreadsheets giving details on about 21,000 of its recent transactions. This data dump wasn’t willing: it was a response to litigation by Bloomberg, and a provision in the Dodd-Frank financial reform law requiring disclosure.

Almost immediately analysts and bloggers sifting through the data honed in on Fed lending to non-US banks, particularly multibillion-dollar loans in October 2008 to Barclays of the UK, UBS of Switzerland, Dexia of Belgium, and several German banks. It didn’t take long to spot the $11.5bn loan to Royal Bank of Scotland, on October 9, 2008. It was the largest to date. Then the loans got even bigger.

However, a close examination of the data shows that foreign lending actually began well before the bankruptcy of Lehman Brothers triggered the 2008 crisis. Indeed, as some have argued – and these data confirm – the crisis began a year earlier, when supposedly safe structured investment vehicles began to collapse during 2007.

The Fed, apparently worried about global ripples, reacted by supporting non-US borrowers with new loans. Its first central bank liquidity swap – effectively a $10bn 13-month loan to the European Central Bank – was in December 2007. At the same time, the Fed began lending through its Term Auction Facility, with nearly all of the first $20bn going to several non-US banks.

Fed officials have claimed they did not know of the need for large-scale intervention in the financial markets until autumn 2008. Ben Bernanke, Fed chair, also testified that “The only way we could have saved Lehman would have been by breaking the law.” Yet the Fed’s new spreadsheets belie these claims. The data show the Fed was lending prolifically abroad in 2007, and then domestically, to investment banks – including Lehman – in early 2008.

Bear Stearns was the biggest, with a $28bn loan in March. But Goldman Sachs and Morgan Stanley were borrowing, too, as were many foreign banks. The data show Lehman borrowed in March 2008 as well, but just $1.6bn, or less than six per cent of the Bear Stearns loan. In other words, the Fed’s new data show it was well aware of the crisis, and had the ability to lend tens of billions of dollars, but it opted to lend primarily to non-US banks. It lent a lot to Bear Stearns, and not as much to Lehman. This is not to say the Fed should have rescued Lehman, too, but rather that the data do not support claims about its own timing and impotence.

An even more troubling conclusion from the data is that – given who the borrowers were, what collateral they posted, and what interest rates they paid – it is now apparent that the Fed took on far more risk, on less favourable terms, than most people have realised. The Fed defends its loans, saying they were repaid with interest. But any banker understands that lending should be assessed when the loan is made, not after the fact. The question is not whether the Fed was repaid, but whether the rate it charged adequately compensated for the risk.

The Fed charged low rates, often almost zero per cent. It says these rates were justified because loans were “fully secured”. However, unlike some Fed disclosures, the data include only the face amount of the collateral, and vague categorical labels. The Fed admits some collateral was inadequate. But without more details we can’t know whether the loans were fully secured, or whether the Fed, by lending at low rates without adequate collateral, was effectively gifting money to borrowers around the world.

This has been a big week for transparency. But whereas the WikiLeaks cables may have revealed too much, the Fed’s new data have revealed too little. We know now the Fed acted earlier, and with wider scope, than was previously understood. But without more detail about collateral, the case for its actions can still not be properly judged. Nevertheless, even these incomplete disclosures suggest that perhaps, during the next crisis, Fed officials will think more carefully about making loans they know will see the light of day. As US supreme court justice Louis Brandeis noted, sunlight is the best of disinfectants.

The writer is a law professor at the University of San Diego, and author of ‘The Match King’

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