When the Fed Goes into the Investment Business

For the first time since its creation in 1913, the Fed has turned itself into a government of the banks

Chronique de Rodrigue Tremblay

" The power to determine the quantity of money... is
too important, too pervasive, to be exercised by a few
people, however public-spirited, if there is any
feasible alternative. There is no need for such
arbitrary power... Any system which gives so much
power and so much discretion to a few men, [so] that
mistakes - excusable or not - can have such far
reaching effects, is a bad system. It is a bad system
to believers in freedom just because it gives a few
men such power without any effective check by the body
politic - this is the key political argument against
an independent central bank."

Milton Friedman (1912-2006)
"The system of banking [is] a blot left in all our
Constitutions, which, if not covered, will end in
their destruction... The issuing power should be taken
from the banks and restored to the people to whom it
properly belongs."

Thomas Jefferson, (1743-1826), 3rd U.S. President
"If the American people ever allow private banks to
control the issue of their money, first by inflation
and then by deflation, the banks and corporations that
will grow up around them (around the banks), will
deprive the people of their property until their
children will wake up homeless on the continent their
fathers conquered."

Thomas Jefferson, (1743-1826), 3rd U.S. President
In 1989, the U.S. government created the [Resolution
Trust Corp.
in effect nationalizing many savings and loans banks
that were in financial difficulties. Similarly, on
February 16, 2008, the British government nationalized
and rescued this bank with about £55 billion ($107
billion) in public loans and guarantees.
During the weekend of March 14-16, 2008, the [Federal
a semi-public and semi-private American central bank
organization, accepted to create a [Delaware-based
in partnership with a (regulated) private bank, the JP
Morgan Chase bank, in order to buy and manage $30
billion of distressed mortgage-backed securities
acquired from a New York-based global but unregulated
investment bank, Bear Stearns, about to
go bankrupt. JP Morgan Chase put $1 billion in the new
corporation, while the Fed invested $29 billion, an
amount that was quickly transferred to JP Morgan
Chase, the new owner of Bear Stearns.
In so doing, the Fed has de facto nationalized a
portion of the portfolio of Bear Stearns, and become
an "investor of last resort" rather than a "lender of
last resort", besides facilitating the take-over of
this investment bank by JP Morgan Chase. [A private
company, BlackRock Financial Management,
->http://en.wikipedia.org/wiki/BlackRock] was also
hired to administer the new Delaware-based corporation
and will attempt to liquidate the acquired securities
gradually over time. The Fed could then recuperate
part or all of its non-recourse "loan" to JP Morgan
Chase, and would retain any excess amount on its
unusual "investment", in the event there is a profit.
There you have it. For the first time since its
creation in 1913, the Fed has turned itself into [a
government of the banks,
and has invested risky public capital in a business
that was in need to be saved quickly from bankruptcy
and liquidation. Thus, the Fed has not only decided
that it is its duty to solve "liquidity crises",
but also "solvency crises"
in the regulated and non-regulated banking sector. In
other countries, such public investments to resolve a
solvency crisis are decided and handled by the
Treasury and the Government, and are later voted into
law. Even in the U.S., that is the way the Resolution
Trust Corp. was created by the Reagan administration
in the late 1990's. In fact, the current banking
crisis is very reminiscent of [the U.S. Savings and
Loan crisis
of the 1980's and 1990's, although this time the
banking crisis is much more severe and much more
I personally do not question the need for avoiding a
panic liquidation of the subprime and other exotic
assets of Bear Stearns, in order to avoid a contagious
domino effect of bank failures and a worldwide credit
crunch, which could have duplicated the failure of [the
Creditanstalt bank
->http://en.wikipedia.org/wiki/Creditanstalt] in
September 1931, an event that precipitated the 1930's
depression. After all, the Fed was established in 1913
to avoid banking panics. What can be questioned is the
way this has been done, the end result being in effect
to subsidize the U.S. banking sector by privatizing
most of the profits derived from the rescue operation
in the hands of a private bank, and nationalizing the
most likely losses in the hands of the Fed and its
backer, the U.S. government. The U.S. Treasury should
have played a much larger role in this bailout, so as
to protect the public interest.
Make no mistake about it. This transaction may turn
out to be enormously profitable to JP Morgan Chase, if
the actions of the Fed were to stabilize the market
for mortgage-backed financial assets in the coming
months, while the Fed guarantees that the new owner of
Bear Stearns would not suffer any loss on a vulnerable
portion of its acquired portfolio.
A more transparent and a more democratic approach
would have called for the Treasury to establish the
equivalent of the old Resolution Trust Corp. to
acquire insolvent Bear Stearns and gradually liquidate
its mortgage-backed and other risky financial assets
over time. The salvaged investment bank could have
later on be sold to an existing bank at a fair market
value, or reinstated as an independent viable
financial entity. The public good could have been
protected by avoiding a financial panic, while
simultaneously precluding a massive liquidation of
jobs at Bear Stearns, and a possible private
enrichment of a private entity under the umbrella of
an unusually risky public investment by the Fed.
I have been an adviser to central banks over my
career, and that is what I would have recommended.

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