Monday, June 7, 2010

CBO's Low Cost Estimate of the Fed's Crisis Actions

At the request of Senator Judd Gregg, New Hampshire Republican and ranking member of the Senate Budget Committee, the Congressional Budget Office has completed a report titled The Budgetary Impact and Subsidy Costs of the Federal Reserve's Actions During the Financial Crisis. See the report at this link: http://www.cbo.gov/ftpdocs/115xx/doc11524/05-24-FederalReserve.pdf

The report, written by Kim Kowalewski and Wendy Kiska of CBO's Macroeconomic Anlaysis Division, comes up with what most willl surely think is a low ball estimate of the subsidy cost of the extraordinary actions during the financial crisis of 2007 and 2008.

From July 2007 to the end of 2008, the Fed's balance sheet grew from $790 billion to $2.275 trillion. Of that total, loans and other types of support extended to financial institution made up $1.686 trillion.

By the end of 2009, direct loans and other support had fallen to $280 billion, but the Fed held just over $1 trillion in mortgage-related securities (which continued to rise through March 2010 to $1.25 trillion).

The report notes that there was also a big change in the composition of the Fed's liabilities. Before the crisis, the biggest liability was $814 billion in currency in circulation (as of July 2007). By the end of 2009, the biggest liability was the $1.022 trillion in bank reserves held by the Fed. At the end of July 2007, by contrast, the Fed held a mere $6 billion in bank reserves.

"In effect, the Federal Reserve financed its activities during the crisis primarily by creating bank reserves rather than by issuing more curency or increasing its other liabilities," the report concludes.

Banks moved their reserves to the Fed after the Fed was authorized to pay interest on those reserves beginning October 1, 2008, due to the passage by Congress of the Emergency Economic Stabilization Act of 2008.

Of course, all these funds placed in reserve at the Fed meant they were not available for lending to the broader economy.

The report attempts to estimate the economic costs of the Fed's actions to stabilize the financial markets. The authors use an approach they call "fair value" to estimate the value of the subsidies, which they admit often corresponds to the market value. "It is the price that would be received by selling an asset in an orderly transaction between market participants on a designated measurement date.

"Subsidies etimated on a fair value basis provide a more comprehensive measure of cost than do estimates made on a cash basis: They take into account the discounted value of all future cash flows associated with a credit obligation, and they include the cost of bearing the risk," the report states.

However, there is a caveat: OMB uses what it calls "a conceptually similar subsidy measure, as specified by the Emergency Economic Stabilization Act of 2008" to estimate the value of the TARP, the Troubled Asset Relief Program.

CBO estimates a $21 billion fair-value subsidy was conferred by the Federal Reserve on the financial system with all its activities.

Only $21 billion? How did we get to a number that low? For starters, the subsidy cost estimate incorporates the fact that most of the loans forwarded have been paid back, thus presumably reducing the value of the cost subsidy.

Of the $21 billion total, $13 billion comes from the Term Asset-Backed Securities Loan Facility (TALF). This seems tiny compared to the $1.25 trillion in exposure to mortgage securities that is still in place.

What about other subsidy costs? Whout the Fed's intervention, Goldman Sachs would no longer exist in its present form. How does one calculate the fair value cost of that subsidy? Morgan Stanley would conceivably no longer exist in its present form. How does one compute the fair value cost of that subsidy? For the Fed, in both instances, it's zero.

The CBO estimates zero fair market subsidy cost for the Primary Dealer Credit Facility and the Term Securities Lending Facility (TSLF) that provide primary dealers with access to short-term liquidity. That's the facility that kept Goldman Sachs and Morgan Stanley from going down -- not to forget the subsidy from the AIG bailout that went via the back door to Goldman Sachs and other investment banks.

What about all the losses that may be forthcoming from AIG? (CBO estimates the present fair value subsidy cost is only $2 billion) What about the fair value cost to Citigroup of the Fed's subsidies? (CBO estimates it's only $2 billion) What about Bank of America ($1 billion)? The estimates for AIG seems beyond rosy. And Citigroup is still just a step above being a penny stock ($3.79 as of June 3), even with the subsidy. What is the fair value subsidy cost to the Fed of salvaging Citigroup from bankruptcy and ruin?

The report does concede a bit of the obvious in the following sentence:

"It bears emphasizing that CBO's fair-value estimates address the costs but not the benefits of the Federal Reserve's actions. In CBO's judgment, if the Federal Reserve had not strategically provided credit and enhanced liquidity, the financial crisis probably would have been deeper and more protacted and the damages to the rest of the economy more severe."

Setting aside the value of the broad economic benefit, however, surely the CBO estimate does not capture the full fair value cost of the subsidy. What's missing from the estimate is any sense of "fair value."

Maybe what we need is a new definition of fair value subsidy cost.

Or, maybe what we need is a measure of the fair value benefit of each subsidy, focused on its impact on the intended financial recipients of each benefit and not considering the broader economic benefit.

From a common sense view, that's the real value of the Fed subsidy. Surely that would be in the hundreds of billions, at minimum.

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