What Elites See When They Look at the Fed

In her Sunday column about the massive 2007-2008 giveaway at the Federal Reserve Bank's discount window, Los Tiempos de Nueva York's Gretchen Morgenson introduces a mystery: Why was the Fed lending so heavily to foreign banks with no discernable interest in U.S. markets? 

When the crisis was full-on in 2008, foreign institutions became even bigger beneficiaries of the Fed's credit programs. On Nov. 4 of that year, the Fed extended $133 billion through various facilities. Two foreign institutions — the German-Irish bank Depfa and Dexia Credit of Belgium — received 39 percent of the money that day.

"The striking thing was the large amount of borrowing that the New York Fed accepted during the crisis from European banks that had only a minimal presence in the U.S. and arguably posed no threat to the U.S. payment system," said Walker F. Todd, a research fellow at the American Institute for Economic Research and a former assistant general counsel and research officer at the Federal Reserve Bank of Cleveland. Such a thing would never have occurred 20 years ago, he added. 

Why indeed would the Fed help out a Belgian bank? At Business Insider, Gregory White gives one possibility: 

Dexia was heavily involved in the U.S. municipal bond market through bond guarantees and, if it collapsed, could have caused problems for the sector broadly, according to Bloomberg.

"If Dexia went bankrupt, it could have been a catastrophe for municipal finance and money funds," said Matt Fabian, a Concord, Massachusetts-based senior analyst and managing director at Municipal Markets Advisors, an independent research company. "The market has extensive exposure to foreign banks."

Dexia isn't alone in this, with Bloomberg also mentioning Depfa as another European bank similarly involved in the muni bond market.

While from a historical perspective this is interesting, it also explains something about the muni market going forward. The threats don't just lie with defaulting cities, counties, or states. But also with banks around the world, that may have guarantees on muni bonds, which investors may or may not be aware of.

Whether you think the market for debt-carrying cities and municipal utilities is sick as a dog, healthy as a horse or just right, this is important news for two reasons: First because when the conversation turns to counterparty risk, we start to hear the faulty morality of "systemic risk" – in which everybody except the two parties who made a deal are considered to be on the hook when it goes bad. Americans who are seeing larger portions of their paychecks eaten up by Ben Bernanke's transitory inflation were never consulted about these dollar creations (dwarfed by subsequent rounds) and wouldn't even know about them now if not for a successful lawsuit against the Fed filed by Bloomberg reporter Mark Pittman. 

Second, we have learned a bit about municipal debt since 2008. The collapse of a loan insurer would increase cities' cost of borrowing, but theoretically it shouldn't destroy the muni market if the cities are still reliably paying. But if your reason for accepting a lower-yielding bond is that somebody is insuring your investment, you don't need to be confident in the city's finances. Since the end of the Build America Bonds program, investors have been taking a closer look at city finances and the results have generally not been pretty. By giving financial institutions like Dexia another place to bail out, the Fed may have stopped a collapse in the muni market in 2008, but it also delayed a long-overdue examination of Bob Rizzo-style accounting practices and disclosure. That one we're going to be working through for a long time to come. 

This may be why the difference between elite and democratic opinion about the Fed is so wide and widening. If you're one of the players you say, "The Fed saved all of us in our time of need," because to you that's exactly what happened. If you're everybody else you say, "I lost my job/saw my 401(k) tank/endured a 25 percent decrease in the assessed value of my house/etc., after the crisis was supposedly over." So do you thank the Fed for saving the banking system or for turning a financial panic into years of pain?