Fed Auctions $40 Billion in Loans to Rescue Banks

Over the past week, the Federal Reserve has auctioned $40 billion in short-term credit to bail out banks who cannot get these loans from other banks. The banks that are getting bailed out may have bad debt on their books from the Subprime Mortgage Crisis.

Since no one knows who has the bad debt, and how much is out there, banks have become afraid to lend to each other because no one wants to get caught with the debt on their books at the end of the year. To keep liquidity in the financial markets, the Fed held two $20 billion auctions on December 11 and December 20. (Source: Federal Reserve Press Release, 12/12/07)

What It Means to You

Since these auctions are loans, the money should get paid back to the Fed, and so it shouldn't cost the taxpayer anything. Of course, if the banks default, then ultimately the taxpayer may have to foot the bill, similar to the Savings and Loan Crisis, which cost the taxpayers $124 billion.

However, if the banks default, it would signal a serious lack of confidence in the functioning of the financial markets. This would probably trigger a stock market decline and even a recession.

To prevent this from occurring, the Fed will continue to schedule auctions throughout January. This should give banks a chance to sort out who has the bad loans on their books and how bad it is. (Source: Federal Reserve, Press Release, 12/21/07).

It would also give these banks a chance to find additional funds, similar to recent action taken by Citibank and Morgan Stanley. (Source: Citi Sells Stake to Abu Dhabi Fund, 11/27/07; Morgan Stanley Posts Loss on Writedown , 12/19/07)

• The Federal Reserve and the 2007 Banking Liquidity Crisis
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