Monetary policy and credit quality cross purposes

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The Fed has taken steps to directly buy up corporate assets through the high quality and ABS commercial paper markets and through GSE mortgage debt. The Fed rationale is to unlock the liquidity crisis in the short-term lending market and try and push down mortgage rates. The objective of the Fed is to provide liquidity while taking a minimum of credit risk. We thought the mortgage purchases were going to be a TARP objective but things change but that is another issue.

These purchases, which promote the quantitative easing Fed policy, could lead to unintended consequences. If the Fed is willing to finance all of the good quality assets which are rated A1/P1 how is poorer quality paper going to be financed? There are only two choices. The firms of lower quality will have to go under or they will have to find a price that will entice buyers of the paper. The Fed will crowd out the banks for higher quality paper which will have serious portfolio balancing effects.

So who are the potential buyers of lower quality financial paper? They will either be money market funds or banks. Both these groups have either a back-stop or deposit insurance but it comes at a cost. Deposit insurance does not mean that banks and money funds are going to take on riskier credits. Money funds will take on any asset which has the potential to break the buck for the funds.

So what are the alternative scenarios for the banks? They could buy this lower quality paper and have it become a larger portion of their loan portfolio or they could walk away from the market and take deposit reserves at the Fed at the Fed funds rate. The first alternative could hurt earnings and equity. This will force banks to take capital from the Treasury and thus loss control of their firms. The second alternative allows for positive earnings while still maintaining control of their institutions. Credit risk is limited.

The choice seems simple. There will be less lending to those who may need it most at any price. A two-tiered system of Fed lending to high quality firms and no lending to those that do not meet the Fed criteria will further develop. There is no solution in the short-run for this problem if the objective is to solve the liquidity crisis as quickly as possible.