The Fed needs a bailout exit strategy

(breakingviews.com) -- The U.S. government's response to the credit crisis has been, on the whole, successful in warding off financial Armageddon. But as the banking system stabilizes, the Federal Reserve's emergency loan and market-support programs could start to inadvertently subsidize unwise risk-taking. To avoid having taxpayers once again on the hook for Wall Street excesses, the government needs a clear strategy for winding the schemes down.

Some -- like the short-term loan auctions, collateral-for-Treasury swaps, financing for commercial paper purchases and foreign currency lines -- are already on the wane. In all, the amount extended under these liquidity facilities has shrunk by over a third from its high late last year. Fed chairman Ben Bernanke says these programs now account for less than $1 trillion of balance sheet capacity.

That's because private sources of short-term capital have bounced back. Today, a bank can borrow dollars on an uncollateralized basis for a month in the interbank market for about 30 basis points, which is more attractive than a Fed loan requiring full collateral, even if it is 5 bps cheaper. In fact, banks only bid for a third of the one-month loans offered in the central bank's June 15 auction.

That's not to say the programs need to be eliminated altogether. Some could remain on the books for revival in future crises, if need be. But any that are retained should be made more expensive. For example, the minimum interest rates on Fed loans should be set above market rates so only distressed institutions turn to them. In that sense they would be like the Fed's pre-crisis discount lending rate, which was a full point above its overnight target. That would provide a safety net, but not a subsidy.

Likewise, collateral requirements for some of the liquidity facilities, loosened during the crisis to allow firms to swap mortgage-backed, corporate and other sometimes worrying assets for Treasury securities, should be tightened to eliminate any credit-quality arbitrage opportunities. The Fed took an important step in this direction two months ago when it reduced the value of some of the $1 trillion-plus of collateral it holds, resulting in a 10% decline in the total amount that could be borrowed against it.

For the short-term liquidity facilities, which are no longer urgently needed, the government should act sooner rather than later. The country's massive borrowing requirements -- an eye-popping $104 billion of notes is on offer this week alone -- may push short-term interest rates up, making the Fed facilities attractive once again. If that happens, it may be harder for the government to snatch away the punch bowl.

Any such resurgence could strain the Fed's balance sheet, which doubled in size to over $2 trillion last year. Although liquidity facility borrowing since then has fallen over $500 billion, it has been offset by the Fed's purchase of assets like Treasury bonds and mortgage-backed securities, and its growing support of the securitization markets.

The Fed's asset-backed security funding program is gaining steam and may eventually total as much as $1 trillion. It appears to have a good chance of reviving at least parts of the moribund securitization market. But again, the pricing and collateral requirements of the loans backing the ABS should be calibrated carefully to allow only those deals that would be viable under normal market conditions to cross the finish line.

Bernanke says the Fed is working on a plan for withdrawing the programs, and keeping vigilant so banks can't use all the liquidity sloshing around the system to take unwarranted risks. Taxpayers hoping to avoid further losses had better hope he has exceptional timing.