When I heard the news that the Federal Reserve Bank of New York is making $85 billion available to American International Group in the form of loans, one of my first questions was about the source of the money. Does the Federal Reserve keep an emergency fund available to bail out companies during financial crises or does it just create the money out of thin air?
My question was answered on last night’s episode of Marketplace. Since the private sector refused to help AIG, the government stepped in to prevent financial meltdown. The $85 billion is taxpayers’ money, but it’s not funded by taxes we’ve paid. The U.S. Treasury Department sells securities to the public in order to raise the funds used for this bail-out. Yesterday, the Treasury Department auctioned short-term investments. The 35-Day Treasury Bill issued yesterday raised $40 billion in one day.
This auction process allows the investor to name their interest rates, and the Treasury picks the best offers. Many people were willing to lend the government money at a 0% interest rate. The median interest rate for all bids was 0.05%. The Federal Reserve, in turn, is lending money to AIG at a variable rate currently above 11%. If AIG is able to sell its assets and pay back the loans to the Federal Reserve over the next two years, the government stands to make a lot of money thanks to the wide spread in interest rates between the Federal Reserve’s borrowing and lending.
Even if AIG does not pay back the loan, the Treasury Department will still be able to pay back its investors. The government will use whatever means necessary in order to pay the investors as agreed, possibly printing money if necessary.
The fact that the government was able to raise a large amount of money at very low interest rates shows that investors are nervous. They’re willing to invest their money at a very low rate in return for a very safe investment.
Updated February 7, 2012 and originally published September 18, 2008.