Fed Prepared to Take Bigger Role in Combating Financial Crisis

By Craig Torres and Steve Matthews

Sept. 18 (Bloomberg) -- Federal Reserve officials are signaling they are prepared to take an even larger role in trying to contain the deepening financial crisis.

A day after Fed officials seized control of American International Group Inc., the Treasury yesterday acted at the Fed's request to fortify the central bank's balance sheet with $100 billion in new cash. Fed officials can use the proceeds to pump money into financial institutions fearful of lending to each other, or to catch the next insolvent bank that's unable to raise capital.

``It is just not credible for the Fed or the Treasury to say they won't put up'' any more money, said Stephen Stanley, chief economist at RBS Greenwich Capital Markets in Greenwich, Connecticut, and a former Fed economist. ``They are the big lender for anyone who runs into trouble.''

Congressional Democrats indicated the Fed has their support to intervene in markets further, while Republicans took the opposite view. The presidential elections, less than two months away, chilled any call to action in Congress to create a publicly funded agency to handle future bailouts.

Using the Fed ``is a backdoor approach,'' said Allan Meltzer, a Fed historian and professor at Carnegie Mellon University in Pittsburgh. ``If Congress wants to subsidize the losses at the taxpayer expense, it should do it'' with a transparent fund that is on the federal budget, he said.

Marshaled Holdings

Since the financial crisis began more than a year ago, the U.S. central bank has marshaled its more than $900 billion in holdings into unprecedented action, lending Treasuries against Wall Street's hard-to-finance bonds and providing loans to protect creditors of failing banks and insurers that threatened the financial system. The Fed's latest additions to its balance sheet come as the crisis has grown to wildfire proportions.

Such intervention in the markets isn't what longtime associates of Fed Chairman Ben S. Bernanke were expecting when he took the helm at the Fed in 2006, succeeding Alan Greenspan.

``We all made our lists about what the Bernanke Fed would be like,'' said Brian Sack, vice president at Macroeconomic Advisers and a co-author of research with Bernanke when he was a Fed Board staff member. ``We didn't realize that policy activism would be the single most defining characteristic. They seem willing to do whatever it takes.''

The $100 billion Treasury is adding to the Fed's balance sheet was probably necessary to build confidence, said Lou Crandall, chief economist at Wrightson ICAP LLC in Jersey City, New Jersey. Of the Fed's $924 billion in total assets, it has $476 billion of Treasuries. Of that, only $196 billion remains free to use for more operations and $85 billion of that may now be needed to accommodate the AIG loan, Crandall said.

Forestalls Questions

``In the absence of the $100 billion, people would have started asking if they are running out of resources,'' Crandall said. The Treasury deposit ``forestalls the question.''

Still, the Fed's actions don't appear to have calmed the panic. Yesterday's 4.7 percent drop in the Standard & Poor's 500 Index means half its gain from the five-year bull market that began in 2002 has now been wiped out. Goldman Sachs Group Inc. and Morgan Stanley, the only two remaining independent brokerages on Wall Street, plunged the most ever. Yields on three-month Treasury bills sank to the lowest since World War II as investors sought the relative safety of government debt.

Uncharted Waters

``We are really in uncharted waters,'' said former Richmond Federal Reserve Bank President J. Alfred Broaddus Jr. ``The question that has to be raised now is, where is all this going to end?''

One cause of the flight to the safest investments is that neither Congress, the Treasury nor the Fed is prepared to establish the rules of intervention. While creditors of Lehman Brothers Holdings Inc. were left to bankruptcy, those of AIG were rescued.

Shareholders lost in every bailout, from Bear Stearns Co. in March to Fannie Mae, Freddie Mac and AIG this month. That created an incentive for investors to dump financial shares and test the government's willingness to insure creditors.

``The whole government backstop hasn't been carried out in an effective manner,'' said Sean Egan, president of the independent rating firm Egan-Jones in Haverford, Pennsylvania. ``It's not just investors who are going to suffer. It's taxpayers too.''

Congressional Democrats said they are content to continue letting Bernanke make his own decisions rather than have Congress create a resolution vehicle with defined rules. Republicans warned the Fed is on the wrong path.

Fed's Authority

Senate Banking Committee Chairman Christopher Dodd, a Democrat from Connecticut, said the Fed can act as an ``effective Resolution Trust Fund'' to buy and dispose of bad debt stemming from the subprime mortgage crisis. ``The Fed has the authority to move in this area,'' Dodd told reporters yesterday.

The ranking Republican on the Senate Banking Committee, Richard Shelby of Alabama, said he wants the Fed to let markets work rather than opt for bailouts.

``Where do we stop, where do we draw the line?'' Shelby said in a Bloomberg Television interview. ``I don't know what road'' the Fed ``is going down,'' he said. ``If they don't watch what they are doing they are going down a path of no return.''

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