The Fed Can Still Do Its Job

The Fed stole headlines Monday, and-refreshingly-it had nothing to do with rate hikes. Huzzah! Instead, the Fed frenzy is all about-wait for it-its new rules for serving as lender of last resort during a crisis. And we are sorry, because we realize that probably sounds sort of boring and not terribly relevant seven years after the last crisis (and who knows how far away from the next crisis). But there is often some big overlap in the Venn diagram of important and boring things. While the near-term market impact is basically nil, investors everywhere will benefit from understanding what's in the rules and whether they'll help or hurt during the next crisis, whenever it occurs.

For the uninitiated, the Fed's new rules stem from the Dodd-Frank Wall Street Reform and Consumer Protection Act in 2010, which sought to end taxpayer-funded bailouts. Now, this has always been a rather gray area, as there is a fine line between what some consider bailouts and the Fed's acting as lender of last resort, which is why it was created in 1913. Most everyone would agree handing buckets of money to a bankrupt institution is a bad idea-better to wind it down and sell off the functional business units to healthy firms. But bank runs happen, and that's where the Fed comes in handy. The Fed didn't do much lender-of-last-resorting in the early 1930s, unnecessarily sharpening that contraction. It did plenty during the following decades, which many credit for the lack of outright financial panics until 2008, when it once again dropped the ball.

So when Dodd-Frank mandated the Fed amend Section 13(3) of the Federal Reserve Act to crimp emergency lending, our eyebrows went up, as any rules curbing the Fed's ability to do its job could exacerbate the next crisis. Monday, we finally got clarity: The Fed will abandon some of the tools it used with AIG and Bear Stearns in 2008, but it retains plenty of flexibility to help when times are tough. Overall, the new rules seem mostly to be window-dressing, designed to satisfy politicians without hampering the Fed during the next crisis.

Here, in a nutshell, are the new restrictions on Fed emergency lending:

• The Fed can no longer create emergency programs for one firm only (i.e., no repeat of the AIG nationalization^[i])
• The Fed can no longer absorb assets from a firm's balance sheet (i.e., no repeat of its absorption of Bear Stearns' allegedly toxic assets, which enabled JPMorgan Chase to buy the teetering investment bank^[ii])
• The Fed cannot lend to insolvent institutions-aka firms that have filed Chapter 11, have entered resolution proceedings under Title II of Dodd-Frank, have entered any other insolvency proceedings, haven't paid undisputed debts due over the last 90 days, or are otherwise determined by the Fed to be insolvent
• Any emergency lending programs must target a certain "identifiable market or sector of the financial system"
• Any emergency lending programs must be available to at least five firms
• The Fed cannot provide emergency funding to firms who will turn around and lend it to ineligible firms

There are a few key things this doesn't do. One, it doesn't prevent the Fed from creating new programs, like 2008's Term Asset-Backed Securities Loan Facility (TALF) or the rest of that year's alphabet soup of emergency funds. Two, it probably won't end bailouts for all of space and time. The rules ban the Fed from making funding arrangements with individual firms. But when push comes to shove, we suspect it will merely shift the onus from the Fed to the Treasury. If there is political will for a bailout, then politicians will probably find a way to make it happen. Voters would ultimately have their say, which they don't with the Fed.

Three, it doesn't prevent solvent-but-illiquid banks from accessing the Fed's discount window, the site of most of its lender-of-last-resort transactions. This simple fact makes most of the restrictions redundant. Most of 2008's emergency actions were deemed necessary because investment banks, broker-dealers and other non-bank financial institutions were barred from the discount window-only banks and bank holding companies could access it. That stipulation drove the big investment banks to turn themselves into normal banks. Goldman Sachs reorganized as a bank holding company. Merrill Lynch married itself off to Bank of America. Getting liquidity to these firms is much, much less of an issue now.

And four, the supposedly tougher definition of insolvent-expanded to include firms that haven't paid undisputed debt over the past 90 days-doesn't really shrink the pool of eligible funding recipients. It wouldn't have applied to any of 2008's major failing firms, including Bear Stearns, AIG and Lehman Brothers. It's one of those things that sounds tough but really just goes without saying: If you've missed undisputed debt payments, you've defaulted, and the market knows it and is probably punishing you for it. Firms in that position were already shut out of emergency Fed funding, which has always been for the illiquid, not the insolvent.

All that said, the rules do leave one big gray area: the distinction between those two words, illiquid and insolvent. Pretend a bank has trouble getting short-term financing on the open market. It has plenty of assets-and those assets exceed its liabilities-but there are some rumors going around, banks are getting panicky, and no one wants to lend to it. As cash on hand dries up, it really doesn't want to start liquidating assets to repay short-term debt coming due, because that would force fire sales at rock-bottom prices and turn the brewing bank run into a self-fulfilling prophesy. Is that bank illiquid, or insolvent?

We're inclined to say illiquid. If it got short-term funding, it would probably be able to ride out the storm and carry on once panic subsided, and its balance sheet was built for the long haul. But in 2008, when that bank was named Lehman Brothers, the Fed and Treasury decided it was insolvent, forcing it to file for Chapter 11. Even though they'd helped JPMorgan Chase buy Bear six months earlier, when it was in an identical predicament. That inconsistency is what sparked panic. So we reckon markets would have welcomed rules that better codified these definitions and added some predictability to the process in future crises.

Overall, though, the changes strike us as benign. Bailouts and "too big to fail" were always more sociological than economic issues. As the Fed reminds the world in its report, banks paid back every cent lent in 2008 and 2009, with interest. Bear Stearns' "toxic" assets also proved profitable for the central bank. Oh, and for all the talk of the AIG deal as some huge bailout, it actually wiped out shareholders, so it wasn't like they walked away with no pain. So that the Fed didn't overcorrect to satisfy bloodthirsty pols is probably a good thing. The financial system has historically functioned best with a Fed able and willing to help during a bank run, and that ability still stands.