The minutes of the June FOMC meeting noted that “several” members suggested that the Committee explore “new tools” to promote more accommodative financial conditions.
Here we speculate about one potential new tool that might be under consideration.<1> We focus on the broad contours of this potential tool and how it could work to ease financial conditions. We leave it up to the lawyers and securities experts to think about the details. The FOMC’s interest in new tools likely means that the Committee believes that its current unconventional policies—asset purchases and communication—are close to reaching their limits, or are generating diminishing returns, as far as their impact on broader financial conditions are concerned.
Chairman Bernanke hinted at one new tool that might be under consideration: something akin to the so-called “Funding for Lending” initiative announced by the Bank of England and the U.K. Treasury.
At his June press briefing, Chairman Bernanke was asked if the Fed was considering something similar to the BOE/U.K. Treasury plan. He said: “We’re very interested in it, and we’re certainly going to follow it. The details are not yet available.”
Some details of the BOE/U.K. Treasury program became available last week. That program is focused on boosting bank lending to U.K. non-financial businesses and households by lowering the cost of funding for U.K. banks that engage in that lending and providing an incentive for banks to increase their lending.
As we discuss below, we believe that if the Fed were to implement a similar program for the U.S., the focus would be on improving households’ access to credit, rather than lowering rates at which banks can fund themselves. The Chairman emphasized that the U.K. program is a joint initiative of the BOE and the U.K. Treasury. We suspect that he was signaling that if a similar program were to be put in place in the U.S., it could involve U.S. Treasury participation. One way the U.S. Treasury might participate would be as a first-loss taker. This would be important because the lending in question could involve some credit risk. In addition, Treasury participation would be an explicit acknowledgement that such targeted lending by the Fed would have a strong fiscal policy and credit allocation component.
Let’s put this potential new tool in a cost-benefit framework, with potential benefits first.
The coverage of the program would be wide. It would be open to banks that can borrow at the primary credit rate. In principle, the new facility would increase the amount of credit supplied by banks, presumably relaxing one of the headwinds holding back the recovery.
Such a program would reduce the need for further asset purchases, which some see as having rising costs and increasingly uncertain benefits.<2>
We are not lawyers, but our interpretation is that such a program would not require invoking 13(3) authority because it could be designed to lend only to discount-window-eligible depository institutions against eligible discount-window collateral.<3> This is significant because the Dodd-Frank Act limited the Fed’s use of its 13(3) authority and imposed stricter monitoring by the Congress.
What about the potential costs/drawbacks of the program? The involvement of the Treasury could be politically problematic. The CBO might assign a probabilistic loss estimate that could have budgetary implications. Even without this, there could be significant congressional backlash against both Treasury and the Fed. If congressional approval is needed, would the Congress acquiesce? In addition, this new facility would be highly controversial within the FOMC, with some participants objecting that it would amount to inserting the Fed into fiscal policy and credit allocation.
Some might argue that such a program is not only unneeded but might even complicate the FOMC’s exit process. U.S. banks currently hold huge reserve balances. Indeed, a question often asked is what will happen when loan demand picks up as the economy strengthens. If that process starts earlier than anticipated, will the Fed be able to remove accommodation quickly enough?
If banks are not lending because, as some have suggested, there’s only tepid demand for new loans given the still-weak economy, would the new credit facility do much to stimulate economic activity?
If banks are not lending because they don’t see enough creditworthy borrowers, would making more funds available to banks really be the answer? The Chairman has emphasized that bank supervisors encourage banks not to overreact to heightened Fed supervision. They should make loans to creditworthy borrowers. Does the Fed really want banks to lower their credit standards? Not likely!
The cost-benefit analysis suggests that for the new credit facility to work, it would have to target a sector where credit supply conditions are a major part of the problem. We believe that the mortgage finance sector might just fit the bill. In the current environment of historically low mortgage rates, we believe that mortgage lending has been restricted by supply factors, in that banks are leery to lend to otherwise creditworthy households mainly because they see conditions imposed by Fannie and Freddie as part of the securitization process as too stringent.
Suppose the Fed started a credit facility where it made longer-term loans to banks in order to fund their mortgage lending activity.<4> We dub such an initiative a Funding for Mortgages program. The loans would be collateralized by home mortgages. The Fed would, in effect, play a role somewhat akin to that traditionally played by Fannie and Freddie.<5> The loans would have a maturity of three to five years, which would (hopefully) allow time for a rebirth of the mortgage securitization market.
Where would the Treasury come in? The Treasury could come in as a first-loss taker. A similar arrangement was done under TALF with the help of a Special Purpose Vehicle.
In principle, the Funding for Mortgages program could take place without involvement by the U.S. Treasury. We believe that the Fed could do it alone under its existing authority. Nonetheless, Treasury involvement would provide additional credit-risk protection for the Fed, especially in light of the longer maturities of the loans. In addition, Treasury involvement would help shield the Treasury from criticism that it was making fiscal policy.
The Funding for Mortgages program could be a hybrid between TAF and TALF, two credit facilities put in place during the 2008/2009 crisis. The TAF-like component is that only depository institutions would be eligible for participation and, thus, the Funding for Mortgages program would not require invoking 13(3) authority. In contrast, TALF required 13(3) authority, in part because it was open to “all U.S. persons that own eligible collateral.” The facility could be TALF-like in that it could involve the Treasury’s participation as a first-loss taker.
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1 Note, however, that the program we discuss would not be an FOMC program, but a program approved by the Board, presumably with consultation with the FOMC.
2 Depending on its design, the program could lead to a further increase in reserve balances, though, at least in principle, the Fed could lend Treasury notes to participating banks instead of cash. Lending securities would be similar to the BOE/U.K. Treasury program.
3 13(3) is the section of the Federal Reserve Act that gives the Fed authority to lend to non-depository institutions under “unusual and exigent circumstances.”
4 Section 10B of the Federal Reserve Act allows the Fed to lend against mortgages on one-to-four-family homes with the maturities of the Fed loans being “as the Board may prescribe.”
5 Of course, a key difference here is that, unlike Fannie/Freddie, the Fed/Treasury would not be buying any mortgage loans from the banks.
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