Fed Takes New Step In Critical Evolution

15 July 2008

Fed Takes New Step In Critical Evolution

The Wall Street Journal

 

The Federal Reserve’s proposed new relationship with Fannie Mae and Freddie Mac — two of the country’s biggest financial institutions — would broaden its regulatory scope, building on its emerging role as the U.S. financial system’s most important regulator.

The Fed on Sunday said it would allow Fannie Mae and Freddie Mac to borrow from its discount window. Under a three-part plan proposed by the Treasury Department, the Fed also would be given a “consultative role” in setting capital requirements and other standards for Fannie and Freddie.

The move marks the latest step in the Fed’s evolution into the top overseer of the nation’s financial system. Since the onset of the financial crisis last August, the Fed has stepped in to shore up credit markets and bolster ailing financial institutions, and in return is accumulating more authority over the companies.

The Fed’s new role — conceived by Treasury Secretary Henry Paulson — could provide comfort to markets that had become concerned over the years about the adequacy of oversight of Fannie and Freddie. And it is another step in putting into reality the Treasury’s blueprint, released in March, for restructuring financial-market oversight. Under that plan, the Fed would be responsible for overall stability of the financial system, with authority to enter any company and access information as necessary.

How such an approach would work in practice remains to be seen. The central bank is likely to reject any scenario in which it is expected to be a supervisor — conducting close oversight as it does for banks — for the government-sponsored mortgage companies. Sharing its expertise as a consultant, however, could provide what Mr. Paulson sought without giving the Fed additional responsibility or authority over Fannie and Freddie that it doesn’t want.

The Fed first expanded the use of its discount window last August, when banks became so wary of lending to each other that money markets threatened to freeze up. It cut the rate that it charged banks to use the loan program and lengthened the terms. In March, as a teetering Bear Stearns Cos. threatened the U.S. financial system, the Fed announced that it would lend to investment banks directly from the discount window, reversing a policy of only lending to banks.

Critics, including Federal Reserve Bank of Richmond President Jeffrey Lacker and former Federal Reserve Chairman Paul Volcker, worry that by expanding its lending programs, the Fed may have opened itself up to moral-hazard problems. If large institutions believe the Fed will bail them out if they get into trouble, they said, the companies may be more likely to engage in more risky behavior.

To prevent firms from behaving recklessly, it makes sense for the Fed to take on a wider regulatory role, analysts said. “You have to have the stick along with the carrot,” said J.P. Morgan Chase & Co. economist Michael Feroli.

Structural changes in the credit markets also argue for an expanded role for the Fed. Loans that at one time would have stayed on banks’ balance sheets are now sliced and packaged into securities by brokers that sell them to investors the world over. If a large broker fails it could be just as damaging as a bank failure. But if the Fed needs to act as a backstop against such a catastrophic collapse, it also needs to exercise the same sort of regulatory oversight, said Lou Crandall, chief economist at Wrightson ICAP.