A History of the Federal Reserve, Volume 2 (118 page)

Frank Wille, chairman of the FDIC, wanted to delay for a few days to see what happened. Preston Martin, chairman of the Federal Home Loan Bank Board, expressed concern that removing ceiling rates would let large banks compete with the commercial paper market and hurt the weaker issuers of commercial paper (Maisel diary, June 24, 1970, 79). Their support was weak at best.

Burns and Mitchell prevailed the following day. On June 23, the Board voted to suspend ceiling rates on CDs of $100,000 or more issued with thirty to eighty-nine days maturity. Citing “uncertainties,” the press release noted that there could be unusual demands for short-term bank credit. It made no mention of Penn Central, but it explained that the action permitted substitution of bank credit for other forms of credit and did not constitute a relaxation of restrictive policy. Robertson dissented, citing lack of evidence of a crisis and expressing skepticism about whether there would be a large runoff of commercial paper. He expressed concern, also, about a “sharp net expansion of total bank credit” (Board Minutes, June 22, 1970, 38).
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No one mentioned one of the major effects of eliminating the ceiling rate. CDs of $100,000 or more could now be bought and subdivided to offer small savers a better return than regulated rates. It did not take long for investment companies to recognize the opportunity. Money market funds began soon after. In little more than a decade, Congress removed regulation Q ceilings on all maturities to stop the drain of funds from thrift associations restricted to offering ceiling rates. The eventual cost, however, was large. Regulation and inflation destroyed much of the savings and loan industry leaving a large debt for taxpayers in the 1980s.

In the immediate aftermath, problems continued in the commercial paper market as lenders left that market. The Board considered direct lending under section 13 of the Federal Reserve Act, which authorized such
loans to solvent businesses unable to obtain loans from standard sources. Authorization for section 13 loans was granted in 1932 as a depression measure but little used.
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The 1970 problem reopened the issue of when the central bank system should make direct loans to supplement its lenderof-last-resort function. By law, a super-majority of five had to approve the loans and the staff had to approve the collateral.
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187. Ceiling rates for CDs with more than 89 days to maturity remained unchanged. Before the change, the highest rate, 7.5 percent for a year or longer and 6.75 percent for 90 to 179 days compared to 8.25, 8.09, 9.60, and 7.5 to 8.0 percent on four- to six-month prime commercial paper, three-month CDs in the secondary market, new 30- to 89-day CDs, and three month euro-dollars respectively.

By July 1, Robert Holland, the Board’s secretary, could report that the market situation had improved. Several large holders of commercial paper continued to have difficulties, and outstanding commercial paper continued to decline at a rate of $200 million a day. The Board discussed several contingencies but agreed only to develop tactics for managing future crises. On July 21, Burns noted that the limited suspension of regulation Q ceilings had been “timely and salutary” (Board Minutes, July 21, 1970, 1). A bailout of Penn Central had not been necessary to prevent a financial panic.

Results
of
Crisis
Management

The System’s response to the Penn Central crisis was appropriate, much better than actions in some earlier crises but not without some weaknesses. Prompt System action permitted the market to adjust, and limited the extent and duration of the problem. The principal weakness was a confusion between supporting the failing firm and preventing the crisis from spreading by supplying reserves to the market. The initial reaction by the administration, to prevent the railroad from failing, confused the role of lender of last resort to the financial system with responsibilities to individual firms.

Despite bankruptcy of the seventh-largest domestic corporation, prompt announcement by the Federal Reserve that it would open the discount window forestalled a possible financial crisis. The Board limited the announcement’s effect by deciding not to make it public. It told the reserve bank presidents who, in turn, told the principal banks. The news undoubtedly spread, but the terms, conditions, and duration of the loans was less clear than it might have been.
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This was a step back from the more forth
right statement that the System made in 1939 at the start of the European war (Meltzer, 2003, 551).

188. From 1932 to 1936, the System made 123 loans valued at $1.5 million.

189. This provision mixed the responsibilities of the Board and the reserve banks. The loans would have to be made by the reserve banks and included in their portfolios. Aside from Maisel and Mitchell, there was little enthusiasm. Governor Sherrill opposed bailouts of individual firms (Board Minutes, July 1, 1970, 3).

190. Bagehot’s ([1873] 1962) classic statement of principles for a lender of last resort criticized the nineteenth-century Bank of England for failing to announce its policy, not for having the wrong policy (see Meltzer, 2003, chapter 2). The Board had not fully learned this lesson in the Penn Central situation.

Member banks increased their borrowing but did not promptly increase the volume of negotiable CDs. Bank loans show a modest increase in early July, much of it a shift from commercial paper. Table 4.9 shows these data.

Borrowing provided the safety net. Aside from the greatly increased bank borrowing from the Federal Reserve, the principal changes occurred slowly. By late August, banks had increased outstanding negotiable CDs more than 60 percent, partly to replace bank-related commercial paper. The latter began a precipitate decline in the fall, accounting for two-thirds of the decline in total commercial paper outstanding by the end of the year.

By claiming a crisis, the Federal Reserve was able to relax regulation Q ceilings. Restricting the change to CDs with thirty to eighty-nine days’ maturity encouraged substitution of short for longer maturity CDs. In October, Burns asked the Board to suspend ceiling rates for CDs of $100,000 or more for all maturities over twenty-nine days. Several governors objected. The Board did not make the change until March 1973 (Board Minutes, October 19, 1970, 3–5).
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Schwartz (1987a, 284) argued later that the Penn Central’s failure did
not create a crisis. Claims to the contrary required that the market was unable to distinguish between the few commercial paper issuers that had problems and those that did not. The CEA (Council of Economic Advisers, 1971, 169–78) found that few corporations suffered from a liquidity squeeze at the time. Removing regulation Q ceilings did not cause an immediate surge in bank CDs and credit, as would have been the case if demands for credit had been subject to severe restrictions.
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191. Congress granted authority to put regulation Q ceilings on temporary stand-by for large CDs in the fall of 1966 and extended the authority several times. A staff memo prepared for the October 19 Board meeting recognized that removing the ceiling rate would improve monetary control by eliminating abrupt changes in the effect of the ceiling rate. The memo argued, however, that removing the ceilings would shift the burden of restrictive policy more
toward housing and state and local government construction, sectors it described as social priorities (memo, Staff to Board of Governors, Burns papers, Box B-B92, October 16, 1970).

During the next few months, the Board considered several times how to conduct future lender-of-last-resort operations. Discussion centered on two supplements to discount window operations. The first would provide conduit loans; a reserve bank would lend to a member bank that would relend to a troubled corporation. The second provided direct loans to corporations under section 13 of the Federal Reserve Act. The issues included when the loans would be made, to whom, for how long, and under what restrictions.

Robertson and Brimmer opposed such lending. “Corporations that were in trouble were probably there because of their own faults. It was not up to the Federal Reserve to rescue any of them” (Maisel diary, July 2, 1970, 91). Maisel argued that the System controlled credit conditions and reserve and credit availability. It could change banks’ decisions to lend by changing market conditions, and it had an obligation to prevent unnecessary failures. Mitchell supported conduit loans but opposed direct loans to corporations. Reserve bank officers were not trained to evaluate firms or their loan applications. Other members were in between.
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After further discussion, the Board agreed unanimously to develop a contingency plan that mainly used conduit loans to supplement open market and discount operations.

The rationale for this program was not made clear. If the Federal Reserve used open market operations and discounting to increase reserves in the economy, the market distributed the reserves to banks. Discounting extended credit to banks that have collateral. There was no need for additional channels. Moreover, the discussion ignored a key political problem. Once
the Federal Reserve began to rescue banks and firms, it would be difficult to avoid pressures to bail out all large or politically connected failures.

192. Calomiris (1994, 50) found a significant effect of the Penn Central’s problems on highest rated commercial paper issuers. These problems appear to have improved after the Federal Reserve opened the discount window.

193. Detroit’s Bank of the Commonwealth had borrowed more than $100 million from the Chicago reserve bank. The reserve bank requested that it reduce the loan by $15 million for eight weeks. Bank of the Commonwealth had $1.5 billion of assets, but the requirement to repay the loan threatened its solvency at a time of heightened uncertainty. The bank had invested heavily in municipal bonds. When interest rates rose, it had large portfolio losses. The Board agreed to assist the bank “with all the money it needed to stay open” on condition that the principal stockholders leave the management and the bank commit its cash flow to increase its liquidity (Maisel diary, July
21, 1970, 95).

The Board resisted these pressures later in the year when Senator Warren Magnuson, chairman of the Commerce Committee, suggested that the Federal Reserve should lend to the Penn Central to provide operating expenses. The Board approved Burns’s letter rejecting the request on grounds that the Board’s only authorization for direct loans, section 13b, permitted ninety-day loans on good collateral to creditworthy corporations. The Board had not used the authority since 1936 and did not believe it was the appropriate vehicle for Penn Central. Nevertheless, the letter said, there was a public interest issue, since continued operation was essential to the northeastern economy. Burns’s letter endorsed legislation that provided federal guarantees of private sector loans. The proposed legislation applied only to railroads. The Board suggested broadening the program to create an Emergency Loan Guarantee Board (Board Minutes, November 24, 1970, letter, Burns to Magnuson).

Conflicts
at
the
FOMC

Conflicts within the FOMC broke into the open at its June 23 meeting. Canada had floated its dollar on June 1. It immediately appreciated more than 3 percent and continued to rise. By December, it was 5 percent above its May value. The manager, Charles Coombs, a strong proponent of fixed exchange rates, reported that the Europeans believed that the United States was trying to force other countries to revalue to prevent a dollar devaluation. “Coombs said he felt this was terrible and that we ought to try to get everyone to agree that we should fight speculators at any cost” (Maisel diary, June 24, 1970, 82). He found no support. Trieber, substituting for Hayes, wanted to support the dollar by reducing inflation but chose to leave interest rates unchanged to achieve increased money growth.

“Mitchell raised a major attack on St. Louis” after Francis (St. Louis) opted for slower money growth (ibid., 82). Mitchell did not want to abandon money growth targets, but he criticized the short time periods that Francis used to measure growth rates. He said the six-month growth rate was 4.5 percent, an appropriate rate. The three-month rate of 9 percent that Francis used was misleading. Brimmer joined Mitchell but also attacked the framework that St. Louis used. Burns then criticized Brimmer for making public forecasts more pessimistic than internal forecasts but interpreted widely as the committee’s view.
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194. Earlier Burns included “the content and circumstances of public speeches” in the guidelines for conduct (memo, Guide to conduct of System officials, Board Records, April 7,
1970). This may have been a reference to Brimmer’s speeches. Evidence suggests that the two did not get along well.