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How the Fed Prepared to Buy Bank Stocks in 2007: Street Whispers

Tickers in this article: AIG BAC BCS C GS JPM MS

The key question Mishkin raised in the Sept. 2007 meeting was whether the Fed should use its 'lender of last resort' powers, as it did in the LTCM crisis and the 9/11 terrorist attacks, or whether issues were beyond its purview.

"The problem here is really the interaction of the financial side with the real side. I'm worried that, as the economy becomes more nonlinear, we have the potential for a vicious circle or a downward spiral... So the big issue here for me is that this nonlinear element is very real right now. The question is what to do about it, and that's what we will be discussing shortly," says Mishkin, in his analysis.

It's precisely the Fed's actions, increasing in their creativity and desperation through the crisis, which makes Mishkin's hypothetical of buying shares in banks ironic.

In the Sept. 18, 2007 meeting, the Fed first broached the idea of a program, eventually called the Term Auction Facility , which would pump safe assets into banks and temporarily cast off risky ones onto the Fed's balance sheet. In TAF, the Fed offered trillions in repurchase arrangements where it would auction off safe assets to banks and take riskier and less liquid ones such as mortgage backed securities off their books for as long as 28-days.

The program was intended to help pump money into increasingly illiquid banks and alleviate strains in the financial system that could harm the real economy, as Mishkin and some Fed officials worried in 2007. Notably, Fed transcripts reveal the program was designed to allow banks to access the Fed's funds in a manner that wouldn't indicate their duress, unlike the so-called 'discount window.'

"By allowing the Federal Reserve to inject term funds through a broader range of counterparties and against a broader range of collateral than open market operations, this facility could help promote the efficient dissemination of liquidity when the unsecured interbank markets are under stress," the Fed stated in a Dec. 12, 2007 press release announcing TAF.

TAF would eventually beget even riskier operations conducted by the Fed such as the Primary Dealer Credit Facility , Term Securities Lending Facility , Term Asset-Backed Securities Loan Facility and direct toxic asset portfolio buys from JPMorgan Chase (JPM) -owned Bear Stearns and AIG(AIG) , in an effort to give banks cheap short-term funding and ease the burdens of risky assets on their books.

It's in the Primary Dealer Credit Facility, an eventual $9.7 trillion program, where the Fed very well may have heeded Mishkin's recommendation and bought bank stocks - by way of overnight repurchase agreements with Wall Street dealers.

PDCF was an overnight lending facility created by the Fed, which was targeted at securities dealers and accepted new forms of collateral as risky as equities, low-rated debts, and unknown unrated financial instruments, in order to help investment banks finance themselves when short term funding markets dried after the collapse of Bear Stearns.