Implicit liquidity support in the US

The FT in the dog end of the year has an insightful article on the Federal Home Loan system. Continuing one of this year's themes - that the hardest core free marketeers are among the most interventionist when it comes to their own business - it points out how the FHLBs are providing state aid to the mortgage banks.

What the FHLB essentially does is raise money cheaply, by virtue of having an implicit state guarantee. It then uses this to provide loans to other financial institutions, against their mortgage collateral.

The important point to grasp is that these loans have quietly ballooned in recent months: as my colleague Krishna Guha recently noted, the Fed’s Flow of Fund data shows that the FHLB system issued new loans to mortgage lenders at an unprecedented annualised rate of $746bn in the third quarter of this year. That was up from practically nothing in the second quarter. And while the FHLB does not name the lucky recipients of this largesse, the cash almost certainly went to institutions no longer able to fund themselves in the normal way – ie through the capital markets.

[...]

The real moral is that investors in Europe’s securitisation market have, in a sense, been sold a pup. In the past decade, the US has often been hailed as the cradle of modern financial capitalism, partly because it has been so wildly innovative in areas such as mortgage securitisation.

But now it is clear that this market innovation was partly built on the presence of an obscure state safety net. Europe’s problem is that in the past decade it has copied US financial innovation – such as mortgage securitisation – without adopting the other safety valves that the US had too.

I'm not sure the US market innovation was 'built' on the existence of the FHLB system: without it, the same securities might well have been issued. But it certainly is proving useful at the moment, just as the (perhaps accidentally) superior design of the FDIC insurance system in the US has thus far prevented a Northern Rock type event.