Moral Hazard of Fed Lending to Non-Banks

The Federal Reserve’s disclosures on the names of the banks that had borrowed at its discount window has shed new light on the practice of Wall Street houses and other non-banks quickly converting to bank holding companies in order to get central bank loans traditionally reserved for depository institutions.

In a bit of irony, a day before the Federal Reserve made these disclosures, Joao Santos and Stavros Peristiani, two assistant vice presidents at the New York Federal Reserve, posted a column to the New York Fed's web site emphasizing that the U.S. central bank "limits" the problem of "moral hazard" by only giving discount window loans to "depository institutions," meaning banks.

FOX Business and Bloomberg News had forced the central bank to release the discount window borrowings after a court battle. The news organizations had argued that the public had a right to know which banks and Wall Street firms had used this lending window, which the Fed launched in 1914. The Fed had previously kept this information confidential, so as to prevent a run on the banks via the "stigma" of borrowing at its dirt-cheap overnight window.

But where's the stigma now, given the fact that these new disclosures show that dozens and dozens of banks here and overseas had no compunction about hitting up the Fed during the crisis?

The stigma argument is now shown to be merely a tissue-thin veneer the Federal Reserve uses to preserve and protect its own presumptive, conscious, ad-hoc monetary policy making.

Rush to Become Banks

During the height of the crisis in the fall of 2008, both Morgan Stanley (NYSE:MS) and Goldman Sachs (NYSE:GS) launched banking units, Goldman Sachs Bank USA and Morgan Stanley Bank N.A., which then visited the Fed’s discount window. Foreign banks and U.S. banks, both little and big, used the discount window, too.

A number of companies either used or launched what are called industrial loan outfits, otherwise called industrial banks, to access government money during the financial crisis. Insurers like Allstate (NYSE:ALL), which owns a thrift unit, GMAC, Chrysler Finance, and American Express (NYSE:AXP) joined Morgan Stanley and Goldman Sachs in hanging out a bank shingle to access taxpayer money, notably via the U.S. Treasury’s Troubled Asset Relief Program, or TARP.

The rationale here was that these companies deserved taxpayer money because their failures posed a systemic risk to the U.S. economy.

The Federal Reserve has historically only published the total amount of borrowing from the discount window on a weekly basis, but not the names of individual banks who took discount window loans.

Goldman and Morgan Stanley's Discount Window Borrowings

Goldman’s bank unit used the Federal Reserve’s discount window six times, receiving $60.5 million in loans. Goldman Sachs confirmed the number of times and the loan amounts.

Morgan Stanley declined comment discount window borrowings via its banking unit. Morgan Stanley and its bank unit, Morgan Stanley Bank N.A. received a total of $8.13 billion in discount window borrowings.

“During the crisis, we tested our systems, including accessing the discount window. The amounts involved were de minimis and the testing was routine,” says Goldman Sachs spokesman Michael Duvally. “The fact that we tested the system to ensure our procedures worked smoothly was made known to senior executives. Routine tests thereafter were considered part of the normal course of business.”

Goldman Sachs president and chief operating Officer Gary D. Cohn told the Financial Crisis Inquiry Commission last June 30 that “we used it one night at the request of the Fed to make sure our systems were linked with their systems, and it was for a de minimis amount of money.”

Goldman Sachs Group Inc.“I think we would not have failed. We had cash."-- Goldman Sachs President Gary Cohn, Vanity Fair, January 2010

“We might have survived the credit crisis without government help.”-- Chief Executive Officer Lloyd Blankfein, Vanity Fair, January 2010

“None of them would have survived,” without government help.--Treasury Secretary Timothy Geithner, who was president of the Federal Reserve Bank of New York during 2008 and 2009, in an interview last December with Bloomberg Television’s “Political Capital with Al Hunt.”

In its quarterly filings with the U.S. Securities and Exchange Commission, Goldman Sachs didn’t disclose that it borrowed heavily from another Fed program, the Primary Dealer Credit Facility, a lending program the central bank had launched during the crisis as an adjunct to the discount window.

Goldman relied heavily on this and other Fed programs right from the start of the crisis, for a total of 84 times between March 18, 2008 and November 26, 2008, with the largest transaction, amounting to $18 billion, taking place on October 15, 2008.

Its loans under other Fed programs totaled $600 billion, data show. The firm’s total borrowing from the Fed's other programs peaked at $35.39 billion on Oct. 21 and Oct. 22, 2008, the data show.

Morgan Stanley

The borrowing occurred “during a time of immense financial turmoil throughout the banking sector and the broader market.”--Morgan Stanley statement.

"There is no question that the entire industry--including Morgan Stanley--benefited from TARP and the other initiatives undertaken by the government to stabilize financial markets." --James Gorman, Morgan Stanley CEO, from his April 2010 letter to shareholders

Morgan Stanley tapped the Fed’s Primary Dealer Credit Facility 212 times, more than any other financial institution. Morgan Stanley was clearly in a near death experience in the fall of 2008.

Morgan Stanley, the second-biggest U.S. securities firm after Goldman Sachs, had borrowed as much as $100.5 billion from other Fed facilities starting on Sept. 29, 2008. That includes $61.3 billion of loans from the PDCF and $39.2 billion from the TSLF, the data show.

Sen. Bernie Sanders (I-VT) would later say that Morgan Stanley received nearly $2 trillion in emergency Fed lending, separate from the discount window.

NY Fed Cites Moral Hazard

Before the disclosures were made, two assistant vice presidents at the New York Fed posted a column to its website, noting the importance of confidentiality at the window, as well as the moral hazard involved in these borrowings.

The officials wrote that the discount window’s confidentiality is necessary, because banks are often reluctant to borrow due to the “‘stigma’ associated with discount window borrowing.”

Quoting two officials with the Federal Reserve Bank of Richmond, the officials added that the “’stigma’ refers to a fear on the part of banks that a negative signal could be conveyed to regulators, other banks, or investors about a bank’s health if that bank is discovered to have borrowed from the Fed.”

They noted: “If a bank worries that borrowing from the discount window will lead other banks to doubt its fundamental solvency, it may avoid the discount window even if the discount window provides the cheapest funds available. Instead, the bank may liquidate marketable assets or try to borrow in the interbank market at onerous terms, further straining these markets and making it even more difficult for other banks to obtain funding or sell assets.

“Thus, central banks typically disclose only a limited amount of information about discount window activity to avoid branding healthy (but illiquid) banks as weak.

“It should be emphasized that confidentiality is not meant to protect the identities of individual banks per se, but rather to make the discount window more effective in dealing with market disturbances.

“Donald Kohn, former Vice Chairman of the Fed, has discussed the stigma problem in past speeches. ‘The problem of discount window stigma is real and serious. The intense caution that banks displayed in managing their liquidity beginning in early August 2007 was partly a result of their extreme reluctance to rely on standard discount mechanisms,’ Kohn noted in a 2010 speech.

“In fact, the need to mitigate stigma influenced the design of some of the lending facilities, such as the Term Auction Facility, created by the Fed during the financial crises.

“…Admittedly, the existence of the discount window may create some moral hazard, but of course, the Federal Reserve limits moral hazard by restricting discount window access to depository institutions that are closely regulated and supervised by federal banking authorities.”

Which may explain why Goldman and Morgan rushed to become bank holding companies.