The Low Rates that Saved Wall Street

In a new One-Pager, Nicola Matthews sums up some of the findings from her analysis of the activities of the Federal Reserve’s special lending facilities set up during the last financial crisis. She contends that the Fed departed from a classical understanding of what central banks should do in liquidity crises but focuses in particular on the lending rates.

“[E]xamination of the data shows that most of the Fed’s emergency facilities lent at rates that were, on average, at or below (sometimes well below) market rates, with the big banks the primary beneficiaries,” she writes. Matthews notes that the top eight individual borrowers paid a combined weighted mean interest rate of 1.49 percent. The lowest rates went to Morgan Stanley and Goldman Sachs in December 2008, at 0.01 percent (on $50 million and $200 million, respectively).

These emergency facilities were also engaged in lending for sustained periods of time: excluding ST OMO and the support given to Bear Stearns and AIG, the average length of the lending facilities was 22 months. Matthews notes that these extended durations suggest that many of the banks receiving support may have been insolvent, rather than merely illiquid.

“So what?” you might ask. This was an extraordinary crisis, and it demanded an extraordinary response. Matthews argues that while Fed intervention was needed, the particular approach it took to its lender-of-last-resort function — “without penalty rates, without good collateral, or for sustained periods of time” — has perpetuated dangerous dynamics within the financial system: “Lending at or below market rates, allowing banks to negotiate these rates through auctions, and rescuing insolvent banks has not only validated unstable banking instruments and practices but also possibly set the stage for an even greater crisis.”

Read it here (pdf). This One-Pager draws from a working paper (pdf) that contains a detailed breakdown of the rates, durations, and recipients of each emergency facility’s loans.