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39 for example in the panic of 1907 john pierpont

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Unformatted text preview: 39 For example, in the panic of 1907, John Pierpont Morgan was asked to play the role of distributing Treasury’s liquidity injection to the defaulting trust companies. This panic and the LOLR function played by Morgan were the origin of the Federal Reserve. But the absence of major financial crises in the United States since the Banking Act of 1933 placed this function in the background. The Fed’s sole purpose was perceived to be price stability and full employment. There was, however, something unconventional about the Fed’s LOLR activities in the current crisis: Because of a lack of adequate authority and infrastructure for resolving the distress of government-sponsored enterprises (GSEs) and large and complex financial institutions, there seemed to be no tool at work other than the Fed’s liquidity injections to get a handle on the crisis. 76 As David Wessel warns in his book, however, the Fed’s war on the great panic is far from over. The Fed has still to mop up the liquidity that it has sprinkled all around. The popular view is that the most important excursions of the Fed were in dealing with the failures of Bear Stearns and AIG. Contrary to this view, we will explain in this chapter that the Fed’s biggest role in the crisis has been in dealing with the mortgage mess that was left by the collapse of Fannie Mae and the Freddie Mac. In fact, since the start of their conservatorships in September 2008, these GSEs have been operating similarly to what a “bad bank” typically looks like at the end of a financial crisis. By buying more than $1.4 trillion worth of GSE debt and GSE-backed securities, the Fed has propped up the value of these bad banks’ securities and the housing market more generally. This massive foray of the Fed into the mortgage market, even if unavoidable in its war on the great panic, raises serious issues about how and when the Fed can retrench from the expansion. This may also curtail its freedom to raise interest rates and mop up the liquidity that it has injected in the economy. Ironically, we will argue, the more that the Fed gets caught up in the rest of the federal government’s expansion into mortgage finance, the more likely it is that its future monetary policy will not be independent and will be largely driven by the need to monetize government debt. We provide some suggestions for unwinding by the Fed, which ultimately needs a restart of the private mortgage markets (for which we propose reforms in Chapter 8). We also discuss whether the special status that is enjoyed by the GSEs in various Federal Reserve operations – in normal times and in emergency – is desirable and how to restrict or eliminate this special status so that the Fed can avoid its current dilemmas in the future....
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39 For example in the panic of 1907 John Pierpont Morgan...

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