Will the Federal Reserve System join the ranks of other government public supported agencies like Fannie Mae and Freddie Mac?

One could argue that they are on the verge of such ignominy.

Never before has the Federal Reserve been under such attack and from all sides. The attacks have gotten so severe that the subject even made the front page of the New York Times today. (See “Under Attack, Fed Chief Studies Politics,” http://www.nytimes.com/2009/11/11/business/11fed.html?hp.) The legislative attack on the Fed continues with the new proposals on financial regulation coming from the Senate Banking Committee. (See “Senate Democrats Seek Sweeping Curbs on Fed,” http://online.wsj.com/article/SB125786789140341325.html?mod=WSJ_hps_LEFTWhatsNews.)

Certainly the leadership of the Federal Reserve seems to be deserving this scorn. Henry Kaufman states bluntly that “there is the Fed’s legacy of its inability to limit past financial excesses. By failing to be an effective guardian of our financial system, it has lost credibility.” (See, “The Real Threat to Fed Independence,” http://online.wsj.com/article/SB10001424052748703574604574501632123501814.html.)

Of course, Alan Greenspan gets his share of the blame for “keeping interest rates too low for too long in the early years of this decade”; for his failure to understand the changes in the financial markets coming from financial innovation; and for his role in the repeal of the Glass-Steagall Act.

But, Ben Benanke must also bear his share in the decline of Fed credibility. He was Greenspan’s co-conspirator, serving on the Board of Governors of the Federal Reserve System during the 2002 to 2005 period in which the Federal Funds Rate was kept below 2.00% from the time he joined the Board until November 2004. For much of the time this Fed Funds rate was around 1.00%. Bernanke was a strong defender of keeping the rates so low, both in terms of economic analysis and speeches.

After Bernanke assumed the position of Chairman he was slow responding to the possibility that the bubble was bursting in the subprime market. Then, Bernanke reacted very strongly to the financial collapse, possibly over-reacted, in the week of September 15, 2008. (See my post of November 16, 2008, “The Bailout Plan: Did Bernanke Panic?” http://seekingalpha.com/article/106186-the-bailout-plan-did-bernanke-panic.)

Congress certainly saw Bernanke in action that week. According to a Wall Street Journal article, which I quoted in the post, “(Hank) Paulson called the leadership in Congress and asked them to have a meeting with himself and Bernanke on Friday evening. The few members of Congress that talked with the press after that meeting said that Bernanke did most of the talking and ‘scared the daylights out of everyone.’ Bernanke got his wish in that Congress ultimately passed the TARP bill, although they did not pass the bill by the next Monday as Bernanke had originally pressed for.

I’m not completely convinced that Congress, deep down, has all that much confidence in a Ben Bernanke-led Federal Reserve System going forward even though President Obama seems to.

Then, the Federal Reserve, under Bernanke’s guidance, flooded the banking system with reserves, leading up the current time where excess reserves in the banking system total more than $1.0 trillion. His concern over this time period has been the liquidity of financial markets. (See my recent post, “Dear Fed: the Problem is Solvency, not Liquidity,” http://seekingalpha.com/article/171826-dear-fed-the-problem-is-solvency-not-liquidity.)

As Kaufman points out in his Wall Street Journal article, the Federal Reserve now has another major conundrum: “How will the Fed reduce its bloated balance sheet?” This is a real problem because the Federal Reserve has subsidized the financing of massive amounts of federal debt and has also provided massive support to the markets for mortgage-backed securities and federal agency issues. As of November 4, 2009, the Fed owned outright $777 billion in U. S. Treasury issues, $774 billion in mortgage-backed securities, and $147 billion in Federal agency debt securities, roughly $1.7 trillion.

In supporting these markets, the Federal Reserve has kept the interest rates on these securities below the level they would have attained without the support of the central bank. The first question is, what will happen to these rates once the Fed stops supporting these securities. Will their rates ratchet upwards?

And, then, what will happen once the Federal Reserve finally decides it needs to let interest rates move up as the economy gains strength? If the Federal Reserve pursues its exit policy of removing reserves from the banking system it will have to take a loss on these securities. No matter though, it will just reduce the amount of funds (its profits) it returns to the Treasury Department at the end of the year.

In a sense, this will make the Fed like Fannie and Freddie in that it can absorb losses deemed necessary by the government for good social reasons. However, the Fed will not have to go to the Treasury with its hand out, as Fannie and Freddie has to, in order to cover its losses because the Fed makes so much profits by being able to create money whenever it wants to.

But, there is another problem: how much upward pressure will the liquidation of the mortgage-backed securities put on interest rates. How much will Congress resist this upward movement in interest rates? What will the housing lobby do to counter-act this move in rates because such a move will certainly not be good for a recovering housing market.

There is another concern: billions and billions of dollars of government debt have been purchased at subsidized interest rates. Helping this along was the extremely low short-term rates resulting from the Fed’s “close to zero” interest rate policy. If I can borrow for six months at, say, 50 basis points or so, and lend these funds out at around 3.00% on 7-year Treasuries, with a “guarantee” from the Fed that the 50 basis points will remain for “an extended period” of time, I have a pretty nice deal.

And, making money in this way doesn’t even include the returns that are available on the “cover” trade.

But, what will happen to those that “underwrote” the placing of the federal debt when the Fed begins to let rates start to rise? How extensive and deep will be the capital losses? Not everyone can make it through the “exit door” at the same time. Will Congress hear about this?

There are additional regulatory issues relating to institutions that are “too big to fail”. These, too, get us into the political realm. Congress is going to want to get their hands into this “solution” as well.

Has the current leadership at the Fed (Republican appointed) brought us to the brink of the government making the Fed into another Fannie Mae or Freddie Mac? Printing money is sure an attractive way to try and achieve social goals. It is interesting that the political party (the Republicans) that was supposedly the strongest supporter of free-market capitalism has brought us to the edge of greater government control of industry (like autos and housing) and financial institutions (like large banks and the Fed).