Thursday, February 26, 2009

Curse of the Zombie Banks Haunts Fed

The Federal Reserve's lending programs have saved the financial system's life. They also could be making its life miserable. That is one takeaway from a research paper by Douglas Diamond and Raghuram Rajan of the University of Chicago, published online this week by the National Bureau of Economic Research. As fresh data from the Fed will show Thursday, the central bank's balance sheet has more than doubled since August 2007. Some Fed programs have helped loosen the credit logjam, including the Term Securities Lending Facility, which lets banks borrow money using mortgage-backed securities and other hard-to-sell assets as collateral. Bloomberg News Ben Bernanke, chairman of the U.S. Federal Reserve, speaks to the House Financial Services Committee in Washington, D.C., U.S., on Wednesday, Feb. 25, 2009. Bernanke spurned outright federal control of U.S. banks in favor of a public-private partnership that the government would eventually exit. But the Fed also might have kept alive weak banks and other institutions having balance sheets stuffed with toxic assets, the two professors suggest. The weak are afraid to sell such assets because doing so would wipe them out, while strong institutions don't want to buy because they are holding out for a fire sale. Without a lifeline from the Fed, the weaklings could have died, putting the assets in stronger hands at cheaper prices. "Central bank intervention to lend against all manner of collateral may not be an unmitigated blessing," Messrs. Diamond and Rajan wrote. The consumer-loan-focused Term Asset-Backed Securities Loan Facility, which will roll out "very soon," Fed Chairman Ben Bernanke said Wednesday, could raise similar problems if consumer credit quality keeps withering. Of course, doing nothing to help credit would have been catastrophic. But "zombie" banks are a reminder that clearing one logjam can make another one even worse.

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