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The Fed's New Bailout Facility goes Far Beyond Central Banking

English business journalist Walter Bagehot ("Badge-ett") was the first writer to lay out the mechanics of the London money market and central banking with Lombard Street, published in the wake of the transatlantic financial Panic of 1873. What most practitioners know about Bagehot boils down to one phrase on the role of central banks:

"To avert panic, central banks should lend early and freely to solvent firms, against good collateral, and at high rates." These are not Bagehot's words but an efficient summary from Part II Chapter VII written by former Bank of England Governor Paul Tucker. It captures all the important stuff.

  • The bank must lend early and freely, meaning they lend at the first sign of stress, rather than after stress has turned to panic.

  • The bank must lend only to solvent institutions. That means the value of their assets (for banks, these are loans and bonds), are greater than their liabilities (deposits and debt).

  • The bank must lend at high rates, so that only the institutions truly in need of this last resort funding will ask for it.

  • The bank must lend against good collateral. Institutions that borrow from the central bank must post sound securities as collateral. Bagehot specifies that, "advances should be made on all good banking securities", and that "No advances need to be made by which the [Central] Bank will ultimately lose."

Over the weekend, the Fed worked up a special funding facility in response to the failures of Silicon Valley Bank and Signature Bank. What they've dubbed the "Bank Term Funding Program" is a solution designed with SVB and many other banks in mind, and it breaks the most important tenants of Bagehot's central banking wisdom.

The banking system is sitting on an estimated $600 billion in unrealized losses on massive bond portfolios. The problem they're all dealing with is interest rate risk, also known as market risk: when market interest rates rise, the market prices of bonds fall. The lower the interest rate on a bond is, the more its market price falls. Banks loaded up on about $2 trillion of bonds in 2020 and 2021, a time when the interest rates on bonds were lower than they'd been in generations. Then an unexpected bout of inflation came, and the Fed hiked rates at the fastest pace in history, which brought down the value of these banks' bond portfolios.

The Fed's new facility is like if I went to a bank and got a loan, posting my used Ford Expedition as collateral, and they lent me the full price it sold for when it was new. It's the type of deal that should never happen in the natural world. The kind of deal that only an institution with a money printer in its basement and losses covered by taxpayers would make.

Suppose that a bank bought a hundred billion dollars of Treasuries and Mortgage Bonds, for $100 billion, two years ago. Suppose the stack of bonds is now worth about $75 billion. This bank can go to the Fed's new facility, post those underwater bonds to the Fed as collateral, and borrow the full $100 billion for a one year term. A Loan-to-Value ratio of 133 percent. Remember, most people can't get a mortgage for more than an 80 percent LTV.

Tenant number one, "good collateral", is broken. The Fed is lending far and above what the collateral is actually worth. They are not, however, putting themselves in a situation in which "the [Central] bank will ultimately lose", as Bagehot wrote. That's because they made a nifty agreement with the US Treasury department by which the Treasury (aka you and I) get to pay the Fed any money it loses on these loans. Nice.

Tenant number two: "at high rates". Does the Bank Term Funding Program even charge the banks a penalty interest rate?

No, according to the terms, borrowers will be charged the market rate at which banks can borrow from each other for one year, plus 0.1 percent. Let's say that one year interest rate is 4.5 percent. Instead of paying $45 million in interest to borrow a billion dollars, they'll pay 46 million. A steep penalty indeed.

The level of corruption in this deal is egregious, and should lay to rest the absurd notion that modern central banks are, as the economists say, "independent".


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