Fed’s $1.2 Trillion in Financial Sector Loans “A Classic Case of Moral Hazard”

Huffington Post, August 22, 2011. Copyright © 2011 TheHuffingtonPost.com, Inc. | “The Huffington Post” is a registered trademark of TheHuffingtonPost.com, Inc. All rights reserved.

During the 2008 financial crisis, when the nation’s banking system seemed on the verge of collapse, President George W. Bush authorized a $700 billion bailout of the financial industry. The U.S. Treasury implemented that program, known as TARP, in an effort to stave off economic catastrophe.

At the same time, and in the years that followed, the Federal Reserve was undertaking its own rescue operation, in the form of private, previously undisclosed loans to banks and other institutions—lending as much as $1.2 trillion, nearly twice the amount of the Treasury bailout, according to a data analysis performed by Bloomberg News and published on Monday.

The scope of the Fed’s private lending had previously only been guessed at, but figures obtained under the Freedom of Information Act by Bloomberg News show that the nation’s central banker issued loans to more than 300 institutions between August 2007 and April 2010, including over 100 loans of $1 billion or more.

While the Fed’s loans likely helped to prevent a complete implosion of the global banking system, analysts say they fear the loans may have contributed to an atmosphere of complacency on Wall Street. Banks that received emergency cash infusions during the crisis may now believe the Fed will always be there to bail them out of trouble, the thinking goes.

“It is a classic case of moral hazard,” Dimitri Papadimitriou, president of the Levy Economics Institute of Bard College, told The Huffington Post.

The Federal Reserve itself had argued that the details of its emergency loans should be kept out of the public eye, claiming that the reputations of the firms involved could suffer if they were seen to be taking money from the government in order to stay afloat. Many of the banks that borrowed from the Fed had previously appealed to the Supreme Court to keep those records secret.

However, an invocation of the Freedom of Information Act forced the Fed to release more than 29,000 pages of documents, revealing the extent to which the financial sector relied on Federal Reserve dollars during the worst days of the crisis.

Given the extraordinary size of the loans, the public has a right to know what happened, said David Jones, an executive professor at the Lutgert College of Business at Florida Gulf Coast University.

“It’s completely valid at some point to say, ‘Who did the borrowing?’“ Jones told The Huffington Post. “It was appropriate, under this special set of circumstances, to divulge the information.”

Among the largest borrowers were Bank of America, which borrowed $91.4 billion; Goldman Sachs, which was in debt for $69 billion; JPMorgan Chase, which borrowed $68.6 billion; Citigroup, which borrowed $99.5 billion and Morgan Stanley, the biggest borrower of all, to which the Fed loaned $107 billion.

In addition, the Fed issued sizable loans to a number of foreign banks, including the Royal Bank of Scotland, which borrowed $84.5 billion; Credit Suisse Group, which borrowed $60.8 billion and Germany’s Deutsche Bank, to which the Fed lent $66 billion. Nearly half of the 30 largest borrowers were European firms, according to Bloomberg News.

While the amount of lending that took place is remarkable, some argue that the Fed’s error was not in issuing the loans, but rather in doing so without setting stronger policy reform conditions for the money.

Dean Baker, co-director of the Center for Economic and Policy Research, told The Huffington Post that Federal Reserve Chairman Ben Bernanke could have attached a “quid pro quo” to the emergency loans—stipulating, for example, that the money would only come through if the banks agreed to do business in a less risky way going forward.

“This is the moment all the banks were on their backs,” Baker said. “The Fed ran to the rescue and got nothing in return.”

A previous disclosure in December found that the Fed issued $9 trillion in low-interest overnight loans to banks and other Wall Street companies during the crisis. The $1.2 trillion figure represents the peak amount of outstanding loans, which occurred on December 5, 2008, according to Bloomberg News.

Some critics contend that while the Fed was right to support the financial sector, the government didn’t do enough to help ordinary citizens who were also seeing their wealth evaporate during the crisis.

Papadimitriou told The Huffington Post that the Fed issued many of its biggest loans during the Bush administration, and that “they didn’t appear to have any difficulty supporting the financial sector, but very much difficulty supporting the real sector, households.”

Consumer spending suffered and unemployment spiked in the wake of the financial crisis, and the economy remains weak today. Output is low, consumer confidence is down and millions are still out of work—factors that have some economists worried about the possibility of a double-dip recession.

The TARP bailout, led by the Treasury, was the subject of much popular ire when it occurred, since it was seen as a case of the government throwing money at the financial sector at the expense of everyday Americans. Similarly, the Fed’s $1.2 trillion in emergency loans were primarily aimed at keeping major financial institutions on their feet.

“One would assume banks are too interconnected, you have to help all of them,” Papadimitriou said. “But if you take households in total, they are also all interconnected. They are also too big to fail.”