With the House's rejection of the $700 billion financial-markets bailout plan, the Federal Reserve and Treasury Department are stuck for now with tools that have been ineffective at stemming the financial crisis -- or that could provoke battles with Congress.
Federal Reserve officials have been reluctant to use again the biggest weapon in their arsenal -- cutting interest rates sharply -- in part because of lingering worries about spurring inflation. Quick action on interest rates now, moreover, might not be timely, because another version of a rescue plan could still emerge.
Without a congressional rescue package, the Fed and the Treasury must continue to deal with problems on a piecemeal basis as they come up, institution by institution, and flooding the market with loans to help struggling firms survive.
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Speaker Nancy Pelosi (left), Majority Whip James Clyburn (center) and House Majority Leader Steny Hoyer (second from right) headed for a news conference on Capitol Hill after the House failed to pass the $700 billion rescue plan for Wall Street.
The Fed has already sharply cut interest rates, from 5.25% to 2%, and it declined to reduce them further in mid-September. In testimony to Congress last week, Fed Chairman Ben Bernanke noted that while the economic outlook could deteriorate sharply, he also remained concerned about inflation, a sign that he wouldn't take rate cuts lightly. The Fed's next meeting is in late October.
Officials hold out hope that Congress will ultimately act on a broad rescue plan. In a statement after the House vote, Treasury Secretary Henry Paulson said he was committed to using "all of the tools available" to him, but added that the toolkit was insufficient without congressional action. "Where we go from here is something we're going to be working on with congressional leaders," he said.
Before the vote Monday, Fed officials did take aggressive new steps -- in conjunction with other central banks -- by announcing plans to flood the financial system with additional cash to help strained financial institutions around the globe.
The Fed said it would double the size to $300 billion of one lending facility called the "Term Auction Facility" aimed at cash-strapped banks. It will also create a new $150 billion program to alleviate year-end funding pressures, and it will expand agreements with other central banks that effectively send dollars abroad, increasing the amount by $330 billion to a total of $620 billion.
As more institutions teeter on the brink of collapse, the government could be forced to put out more fires through existing authority.
The Federal Deposit Insurance Corp., which has extensive experience handling the bad assets of failed banks, is required to pursue options with the least cost to the government. In consultation with the Treasury and Fed, however, the FDIC could waive that provision -- due to the risk of severe economic troubles -- and bail out banks to guard against further turmoil. Among its options, the FDIC could signal that creditors would be paid off in the case of a bank failure -- effectively preventing more problems that could further undermine credit markets.
"There's really expansive authority for the FDIC to prevent systemic risk," said Michael Bradfield, a partner at Jones Day and former Fed general counsel. Waiving the usual FDIC procedures could "make banks willing to lend to one another, if they knew that regardless of who they lent to they were going to get bailed out if that bank failed."
The Fed, with Treasury's consent, in March put up $30 billion to save Bear Stearns Cos. from total collapse and facilitate its sale. In that case, the Fed took on mortgage assets directly, including some that would be included in a bailout program Congress has been considering. The central bank conceivably could use the same authority to take on more assets.
President George W. Bush, Mr. Paulson and congressional leaders might support emergency asset purchases by the Fed. But taking that action now "could be interpreted as a back door around Congress," said Vincent Reinhart, a former top Fed staffer who is now at the American Enterprise Institute. Sidestepping democratically elected lawmakers for the sake of financial stability would be fraught with risks.
The Treasury could take other incremental steps to help mitigate the crisis, including further expanding its program to buy mortgage-backed securities issued by the mortgage titans Fannie Mae and Freddie Mac. The new program, created during the government's recent takeover of the companies, has already doubled to buy $10 billion of MBS backed by Fannie and Freddie.
While buying debt issued by Fannie and Freddie could relieve some pressure, those securities aren't the toxic assets the government believes it needs to remove from financial institutions in order to restart credit markets.
"They're limited in what they can buy. It's just Fannie and Freddie debt, so it helps but just a little bit," said Douglas Elmendorf, a senior fellow at the Brookings Institution and a former Clinton economic adviser.
The Treasury could also turn to a Depression-era fund to find money for loans or loan guarantees to financial institutions. The Exchange Stabilization Fund has about $50 billion in it, and the Treasury could use that money to backstop financial firms. However, it's a small amount, compared with the $700 billion the Treasury said it needs to stem the problem.
The Treasury has already announced a plan to tap the Exchange Stabilization Fund to insure money-market mutual funds, which could complicate efforts to siphon off funds for another purpose. In 1995, after Congress refused the Clinton administration's $40 billion rescue package for Mexico, the administration turned to the fund to offer Mexico as much as $20 billion in loans and loan guarantees.
"I presume they could do that again, though it would likely attract a lot of criticism," says C. Fred Bergsten, director of the Peterson Institute for International Economics.
Interbank lending markets have been under worsening strain for weeks, and the failure of the rescue plan in Congress is sure to worsen that. One indicator of the stress: Interest rates on three-month interbank loans have soared to more than two percentage points above the expected federal-funds rate -- the central bank's benchmark overnight lending rate.
When this rate is high, it demonstrates the unwillingness of banks to lend to each other. In normal times, there is little gap between the two rates. In March, when Bear Stearns collapsed, the gap widened to 0.85 percentage point. It has now surged to more than two percentage points.
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