Fed Direct Loans Lose Stigma as Banks Push Borrowing to Record

By Scott Lanman

Sept. 12 (Bloomberg) -- Commercial banks that a year ago rebuffed a Federal Reserve program to provide cheaper cash may be increasingly dependent on it.

Borrowing from the Fed's discount window hit record levels in six of the past eight weeks, and reached $23.5 billion as of Sept. 10, Fed data show. By comparison, lending averaged just $779 million a week in the three months after New York Fed President Timothy Geithner urged banks to use the program.

The increasing use of the funds risks delaying banks' disposal of nonperforming assets and capital raising. It also may make it tough to restore the rate on the loans to the historical 1 percentage point premium over overnight funds, analysts said. The Fed has lowered the rate nine times since August 2007.

The low cost may ``delay necessary adjustments'' at banks, said Vincent Reinhart, a resident scholar at the American Enterprise Institute in Washington who was director of the Fed's monetary affairs division from 2001 to 2007. Lenders may ``have a hard time if the Federal Reserve tries to take it away,'' he said.

Geithner, along with Fed Vice Chairman Donald Kohn, told a group of banks including Citigroup Inc., JPMorgan Chase & Co. and Bank of America Corp. on an Aug. 17 conference call that tapping the so-called discount window was a ``sign of strength.''

They were combating what officials called a ``stigma'' -- that borrowing from the Fed was an indication of serious weaknesses. Policy makers later expressed frustration about the discount window as a tool for injecting funds into the financial system, and rolled out alternative programs.

Longer Terms

Banks had cheap funding during the credit boom, when bond yields reached half-century lows. With mounting losses from the mortgage debt market and the economic downturn, they are rushing to the Fed instead. Borrowing has climbed since March, when the Fed lengthened the term of the loans to 90 days.

The discount rate is now 2.25 percent, compared with a 2.82 percent rate for three-month funds lent between banks. The Fed's benchmark federal funds rate is 2 percent.

``The problem is, you can never go off the methadone,'' said Jim Bianco, president of Chicago-based Bianco Research LLC, referring to a drug used to wean addicts off of heroin.

Along with the discount-window lending, the Fed also provides $150 billion of funds to commercial banks through cash auctions, where it receives collateral including mortgage-backed debt. For investment banks, the Fed has a $200 billion program for lending Treasuries, also in exchange for a variety of collateral.

Fed Credibility

By depleting its store of Treasury securities and taking on asset-backed securities, the central bank is diminishing the quality of its balance sheet, said former Richmond Fed President Al Broaddus. That may eventually hurt the Fed's credibility in other ways, including its monetary-policy commitment to keep consumer prices stable, though such a result isn't ``anywhere near'' yet, he said.

Central bank lending from the discount window ``should not continue to grow and persist over a long period of time,'' Broaddus said. ``That needs to be watched and managed very carefully.''

Fed Vice Chairman Donald Kohn said in May the central bank should eventually phase out its special lending programs, giving way to private lenders.

``Central banks should not allocate credit or be market makers on a permanent basis,'' Kohn said. ``That should be left to the market.''

Funding Strains

Moving the discount rate back toward the 1 percentage point premium and overnight duration may be difficult as funding strains remain and financial turmoil continues.

Lehman Brothers Holdings Inc. has lost 74 percent of its value this week on concern it lacks sufficient capital to offset losses. Fed and Treasury officials are helping the company, which lost $3.9 billion in the third quarter, locate a potential buyer, a person with knowledge of the matter said yesterday.

The collapse of the U.S. subprime-mortgage market has led to losses and writedowns by financial institutions totaling $511 billion since the beginning of last year.

A gauge of bank funding costs, a premium on three-month bank loans over the overnight indexed swap rate, which is a measure of what traders expect for the Fed's benchmark rate, rose to 84 basis points yesterday, compared with 69 basis points three months ago.

``The markets are in disarray,'' said Chris Rupkey, who follows the Fed as chief financial economist for Bank of Tokyo- Mitsubishi UFJ Ltd. in New York. While central bank policy makers are leery about increasing aid to banks, ``at this point the Fed's hands are tied.''

The Fed's new liquidity tools may prove to be long-lasting policy instruments once the crisis does subside, Bianco said. They could become routine mechanisms for adjusting credit, in the way the federal funds rate became the benchmark around 1990, Bianco said.

``What was set up to be temporary is now starting to look like it's becoming permanent,'' he said.

To contact the reporter on this story: Scott Lanman in Washington at slanman@bloomberg.net