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Since the onset of the liquidity and credit crunch last summer this column has been arguing that monetary policy would be impotent to address such a crunch because, in part, of the existence of a non-bank “shadow financial system”. This system is composed of conduits, SIVs, investment banks/broker dealers, money market funds, hedge funds and other non bank financial institutions. ... What we are now observing – with the case of Bear Stearns and the recent disaster among SIVs, conduits, run on a number of hedge funds and money market funds is a generalized liquidity run on this shadow financial system.

The response of the Fed to this run has been radical and in the form of the extension of the lender of last resort support to non bank financial institutions. Specifically, the new $200 bn term facility allows primary dealers – many of which are non banks – to swap their toxic mortgage backed securities for US Treasuries; second, the Fed provided emergency support to Bear Stearns and following the purchase of Bear Stearns by JPMorgan, is now providing a $30 bn plus support to JPMorgan to help the rescue of Bear Stearns; finally, now the Fed is allowing primary dealers to access the Fed discount window at the same terms as banks.


This is the most radical change and expansion of Fed powers and functions since the Great Depression: essentially the Fed now can lend unlimited amounts to non bank highly leveraged institutions that it does not regulate. The Fed is treating this run on the shadow financial system as a liquidity run but the Fed has no idea of whether such institutions are insolvent. As JPMorgan paid only about $200 million for Bear Stearns – and only after the Fed promised a $30 billion loan – this was a clear case where this non bank financial institution was insolvent.


The Fed has no idea of which other primary dealers may be insolvent as it does not supervise and regulate those primary dealers that are not banks. But it is treating this crisis – the most severe financial crisis in the US since the Great Depression – as if it was purely a liquidity crisis. By lending massive amounts to potentially insolvent institutions that it does not supervise or regulate and that may be insolvent the Fed is taking serious financial risks and seriously exacerbate moral hazard distortions. Here you have highly leveraged non bank financial institutions that made reckless investments and lending, had extremely poor risk management and altogether disregarded liquidity risks; some may be insolvent but now the Fed is providing them with a blank check for unlimited amounts. ... This is the worst US financial crisis since the Great Depression and the Fed is treating it as if it was only a liquidity crisis. But this is not just a liquidity crisis; it is rather a credit and insolvency crisis. And it is not the job of the Fed to bail out insolvent non bank financial institutions. If a bail out should occur this is a fiscal policy action that should be decided by Congress after the relevant equity holders have been wiped out and senior management fired without golden parachutes and huge severance packages.

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