Fed Loans to Failed Banks Made Easier by Fannie-Freddie Rescue

By Craig Torres

July 31 (Bloomberg) -- The Federal Reserve will be able to lend more easily to failed banks under government control because of a provision in legislation that bailed out Fannie Mae and Freddie Mac.

In the rescue signed into law by President George W. Bush yesterday, the Fed will no longer have to pay penalties on loans it makes to institutions taken over by the Federal Deposit Insurance Corp.

The measure may mean more use of the central bank's balance sheet to prop up the U.S. financial system, after the Fed began lending to investment banks in March, analysts said. The FDIC has taken over seven banks this year, with 90 on a watch-list of troubled firms as lenders are hit by the surge in credit losses.

``We are pushing forward the line on what the government will backstop, and what the Federal Reserve will backstop,'' said Vincent Reinhart, former director of the Fed's Monetary Affairs Division who is now at the American Enterprise Institute in Washington.

Fed officials yesterday also extended their two lending programs to Wall Street through January, after judging that markets are still ``fragile.''

The Federal Reserve Act's Rule 10B penalizes the Fed for loans to undercapitalized institutions exceeding specific time periods. The original provision was aimed at preventing the central bank from keeping failing banks open.

FDIC Request

The exemption in the new law, which was requested by the FDIC without objection by the Fed's Board of Governors, was aimed at making clear that once banks are taken over by the FDIC, capital rules no longer apply because they are effectively owned, operated and in liquidation by the government.

``It is more of a clarification,'' said FDIC spokesman Andrew Gray in Washington. ``It removes any ambiguity from the current statutory language.''

Fed spokesman David Skidmore declined to comment.

For some, the exemption opens up the Fed to more political pressure to lend to government agencies, instead of forcing Congress, the FDIC, or the Treasury to explain to taxpayers why they need more money.

``Once the Fed starts lending to a bridge bank, or indirectly to the FDIC, where is the incentive to ever stop?'' said Walker Todd, a former Cleveland Fed attorney and visiting research fellow at the American Institute for Economic Research in Great Barrington, Vermont.

The FDIC had $52.8 billion in its deposit-insurance fund as of March 31. The FDIC could raise more money by tapping a $40 billion credit line it has with the U.S. Treasury, increasing assessments on its members, or turning to Congress.

Bridge Bank

``Like any open depository institution, there will be short-term borrowing needs by the bridge bank,'' which may need to ``tap the discount window,'' Gray said, referring to the name for the Fed's direct loans to commercial banks. ``Longer-term borrowing needs would typically be met by a loan from the FDIC.''

The Fed enjoys wide discretion in discount-window lending, and demands collateral, sometimes in excess of the loan's value, to insure against the risk of default.

A request by the FDIC could always be rejected by the central bank. Still, the removal of the penalties may open up the Fed to more political pressure, possibly encroaching on its independence, analysts said.

`Costly and Difficult'

``Why should they be doing it?'' said Robert Eisenbeis, former Atlanta Fed research director and now chief monetary economist at hedge fund Cumberland Advisors LLC. ``The whole idea'' of the rules in the Federal Reserve Act is ``to make it costly and difficult to support an insolvent institution.''

This month, the Fed board voted unanimously to allow direct lending to government-sponsored housing agencies Fannie Mae and Freddie Mac ``should such lending prove necessary,'' at the request of U.S. Treasury Secretary Henry Paulson.

Yesterday the central bank extended until Jan. 30 the Primary Dealer Credit Facility for direct loans to securities firms and the Term Securities Lending Facility for loans of Treasuries, both begun in March. The programs will be canceled when the Fed deems that markets ``are no longer unusual and exigent,'' according to a statement from the central bank.

The Fed will start auctions of options of as much as $50 billion in the TSLF on top of the $200 billion program, which loans Treasuries to securities firms in exchange for asset- backed securities and other collateral.

New York Fed officials plan to consult with the primary dealers of U.S. government bonds on the TSLF options program, the district bank said in a statement yesterday. The options plan is aimed at providing liquidity for two weeks or less surrounding key financing periods to be identified. Further details are planned on or before Aug. 8, the New York Fed said.

To contact the reporter on this story: Craig Torres in Washington at ctorres3@bloomberg.net