Bob Ivry has done a solid job of reporting on some of the documents that Bloomberg forced the Fed to release through a Freedom of Information Act request. In short form, the Fed created a special facility called the single-tranche open- market operations. It was established in March 7, 2008, the week before the Bear meltdown, and continued through the end of December. The facility size was $80 billion and the program was limited to 20 primary dealers. Three groups, Credit Suisse, Goldman, and Royal Bank of Scotland each borrowed at least $30 billion at various points.

Why is this program now controversial? First, Congress appears to have overlooked it in its Dodd Frank drafting. Barney Frank is quoted saying he never heard of it. But more troublingly, its use appears to have morphed from an “keep the markets from seizing up” by providing more liquidity in the repo market, to a back door prop to the banks. Admittedly, the numbers paled compared to the TARP, but here we have the Fed either deliberately or incompetently handing cash to the banks (we assume deliberately since anyone could see how cheap the funds on offer were). Key extracts:

They paid interest rates as low as 0.01 percent that December, when the Fed’s main lending facility charged 0.5 percent. “This was a pure subsidy,” said Robert A. Eisenbeis, former head of research at the Federal Reserve Bank of Atlanta and now chief monetary economist at Sarasota, Florida-based Cumberland Advisors Inc. “The Fed hasn’t been forthcoming with disclosures overall. Why should this be any different?”… In March 2008, ST OMO was “desperately needed,” because of the shaken state of short-term credit markets, said Michael Greenberger, a professor at the University of Maryland School of Law in Baltimore and former director of the division of markets and trading at the Commodities Futures Trading Commission. After the Fed created other lending mechanisms and the Treasury Department began distributing money from the Troubled Asset Relief Program in October, ST OMO became “just a way for banks to have at it,” he said. “At such low interest rates, it’s no longer a rescue, it’s a profit-making enterprise,” Greenberger said. “By December, a lot of money was made off this program.”

Let’s draw out the implications. The Fed was concerned enough about the health of the biggest banks in the world so as to be handing out covert freebies. Yet it did not saddle up for a serious examination of how fragile these firms were. In fact, as Joe Gagnon, a former Fed official, said at a recent Roosevelt Institute conference on the Fed, the monetary side of the Fed was concerned about the banks (how could you not be when the banks weren’t willing to lend to each other), yet the regulatory side blew off their concerns. As we said in March 2008, everyone knew that Lehman, Merrill, and UBS were at serious risk. Lehman was in a constant PR offensive, trying to deny charges that turned out to greatly understate how weak the firm was. Credit default swaps were seen as the reason that Bear, a firm no one would have designated as systemic in 2006, had to be rescued. Yet all the Fed did was send two examiners to Lehman (which admittedly was more than the SEC, its nominal lead regulator, did). Instead, the Fed should, in concert with the ECB and Bank of England, should have gone and made a serious risk assessment.

The complacency of the regulatory side of the Fed, particularly in light of what amounts to covert action on the monetary side, suggests that the Fed has governance problems that likely remain unaddressed (there has been remarkably little in the way of soul-searching by the Fed; if anything, it seems proud of the job it did during the crisis, rather than seeing the fact that the crisis happened as a hanging crime).

This apparently intentional misuse of liquidity facilities is further proof of dysfunction at the Fed. All we can hope is that the crisis revelations will unearth enough dirty laundry to produce pressure for far more transparency and accountability from the central bank.