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“The Fed lent freely, but at a low rate, on dodgy collateral”

My view is that the Fed’s role should be circumscribed. Nevertheless, the Fed serves an important function in the US and global economy in providing liquidity, as we have witnessed during the crisis. It is the American – and in many respects, the global – lender of last resort. Walter Bagehot wrote an eponymous financial book in the 19th century called Lombard Street, giving advice on finance and banking. The most important and quoted piece of advice Bagehot gave was to the Central Bank, in this case the Bank of England. He told them to "lend freely at a high rate, on good collateral."

This is something the Federal Reserve has failed to do during the credit crisis. The Fed lent freely, but at a low rate, on dodgy collateral. This was true even before Lehman collapsed. See the Wall Street Journal’s "Bye, Bye Bagehot" article on Fed lending under the Term Auction Facility from January 2008 for example. The setup of the Fed’s Primary Dealer Credit Facility had the clearing banks determine the haircuts banks had to take for taking loans from the Fed. The result has been an inability of market participants, regulators or the wider public to differentiate between the truly insolvent companies and the illiquid. The resulting lack of confidence in the entire financial system and by financial institutions in each other has been damaging to the global economy.

This is the crux of the Fed’s problem – and its conduct during the crisis is emblematic of the untenable role of the institution as both regulator and servant of the financial services industry.

-Some Thoughts On The Fed and Bank Bailouts,Dec 2010

The role of a central bank in a crisis is to act as a lender of last resort by helping market participants discriminate between the truly insolvent and the unfortunate illiquid. If the Central Bank lends against good assets at a penalty rate, the truly insolvent financial institution goes bust but the unfortunate illiquid institution gets bailed out. I have been making this point for quite some time.

  • Nov 2008 (Bloomberg News sues the Fed under Freedom of Information Act): For those of you concerned about the Fed’s risky behavior, its ballooning balance sheet, and its acceptance of dodgy collateral, well you may be about to see whether the American democracy can allow this unchecked power to continue without oversight. Bloomberg News has sued the Federal Reserve to force them to reveal what kind of collateral they are accepting in loaning out trillions of dollars to U.S. banks.
  • Nov 2008 (Bailout Nation): we come to American Express. Apparently, the U.S. Government feels that American Express needs to get on the gravy train as well given that they just granted the company authorization to become a bank holding company. Bank holding companies can borrow at low rates from the Federal Reserve, offering up dodgy collateral like Asset-backed securities in turn. That is why all of the investment banks have become bank holding companies and that is also why the Federal Reserve has been sued by Bloomberg News to find out just what kind of collateral these companies are using.
  • Jun 2009 (Will banks exiting TARP take back their toxic waste now?): This has not been a liquidity crisis. It is a solvency crisis. The banks are not well-capitalized because the stress tests were just a big charade and an effort to buy these firms time. Moreover, it is painfully obvious that the banks are very much dependent on the government still – or they would be getting their dodgy assets back.

    Meanwhile the Bloomberg lawsuit filed under the Freedom of Information Act to uncover what kinds of assets the Fed is now holding as collateral is still ongoing.

    So, if you are wondering like me, when the Fed is going to start shaping up its balance sheet or when the Fed is going to come clean about what kinds of dodgy assets it now holds on that balance sheet, you’re likely to be waiting for answers for a very long time.

  • Oct 2010 (Grantham: Night of The Living Fed): [Jeremy] Grantham sees the Fed at the centre of four major events in the post-bubble era: runaway commodity prices, zombie banks that don’t lend enough to customers or issue dividends to investors, the foreclosure crisis, and ‘the currency wars.’ I have written endlessly about the Fed’s machinations to pump up asset prices via an asymmetric policy which promotes the accumulation of debt. Like Grantham, I am coming to the conclusion that the Fed needs a lot less power. Even in the circumscribed role which Grantham would permit the Fed, we had to marvel at how it passed out favours to the banks via buying up dodgy collateral for loans at low rates. Moreover, on that very score, let’s not forget the secrecy with which the Fed is trying to operate. It has taken a lawsuit to the Appellate courts to get them to come to heel. Of course, the Dodd-Frank legislation passed by Congress and supported by the Obama Administration gives the Fed more not less power.

Well, now the Fed has finally been forced to come clean by the Bloomberg and Fox News lawsuits. And, whocouldanode, they lent $118 billion against dodgy collateral just as I have ben saying.

Headline: Fed Let Brokers Turn Junk to Cash at Height of Financial Crisis

At the height of the financial crisis, the Federal Reserve allowed the world’s largest banks to turn more than $118 billion in junk bonds, defaulted debt, securities of unknown ratings and stocks into cash.

Collateral of those asset types made up 72 percent of the total $164.3 billion in market-rate securities pledged to the Fed on Sept. 29, 2008, two weeks after the bankruptcy of Lehman Brothers Holdings Inc., according to documents released yesterday. The collateral backed $155.7 billion in loans on the largest day of borrowing from the Primary Dealer Credit Facility, which was created in March 2008 to provide loans to brokers as Bear Stearns Cos. collapsed.

Did you do the math? $155.7 billion/$164.3 billion is a haircut of 5 1/4%. Sounds pretty generous to me, especially when 72 percent of the collateral is junk.

The cushion “was far too small for the risk of the underlying collateral,” [Craig Pirrong , a finance professor at the University of Houston] said. “Collateral that’s junk or defaulted debt and equities at a time when market volatility was huge is pretty eye opening.”

Exactly.

Here’s a chart from Yves Smith’s book ECONNED that she put up this morning.

Typical Haircuts

Those aren’t the terms on which the Fed was lending money.

Here’s the thing, if the Federal Reserve was so frightened about what would happen if it didn’t lend freely at a low rate against junk collateral, then why aren’t we making sure too big to fail banks are better capitalized? Instead we are relying on resolution authority as if that is going to stop a panic. And to top it off, people like Greenspan who Tom Hoenig says helped caused the bubble are telling us that even the lame Dodd-Frank bill with its resolution authority is too much. Are you kidding me?

So, here’s the sequence of events (see The Dummy’s Guide to the US Banking Crisis):

  1. Early in the 2000s, scared of deflation, the Fed drops rates to 1%, helping to cause a housing bubble as Fed President Hoenig says.
  2. In an anti-regulatory mood, the Fed then relaxes leverage rules for investment banks.
  3. Investment banks leverage up as excess credit flows into housing via asset-backed securities.
  4. The Fed hikes rates starting in 2004, aghast at the froth it has unleashed.
  5. By Feb 2005, Alan Greenspan wonders aloud about the conundrum of easy money, animal spirits and low rates. Bernanke invents the Asian Savings glut theory as intellectual cover for the Fed’s actions.
  6. In 2006, things start to unravel when those that could least afford to purchase homes — so called subprime borrowers — start to default, prices having run well out of their range of affordability
  7. Banks get hammered on losses starting in 2007 with the Household International credit writedown by HSBC. Fed Chair Bernanke says, "At this juncture . . . the impact on the broader economy and financial markets of the problems in the subprime markets seems likely to be contained."
  8. Later in 2007, a liquidity crisis hits anyway, taking British bank Northern Rock down.
  9. By January 2008, things spiral out of control, so the Fed starts lending money at low rates against collateral under the Term Auction Facility.
  10. In March 2008, the Fed organizes a takeover of Bear Stearns by JPMorgan Chase, leading market participants to believe no one could fail.
  11. In August 2008, Fannie and Freddie get a government backstop.
  12. By September 2008, without a clear sign as to which firms were insolvent and which were illiquid, market mistrust creates fear.
  13. Lehman heads to the wall with implicit thoughts of a Fed backstop due to the Bear deal. They are not bailed out. Panic ensues.
  14. Now, the Fed acts as a lender of last resort. But it gives money to any and all takers, against whatever dodgy collateral at a low rate without significant haircuts.
  15. Scared of deflation again , the Fed drops rates to 0%, helping to cause a commodities bubble as Fed President Hoenig says.

Does that sound like insanity to you? Question: if 1% rates for an extended period last decade got us a housing bubble, why should we expect zero rates to be a good thing? The definition of insanity is is repeating the same behaviour and expecting different results.

Just sayin’.

About 

Edward Harrison is the founder of Credit Writedowns and a former career diplomat, investment banker and technology executive with over twenty years of business experience. He is also a regular economic and financial commentator on BBC World News, CNBC Television, Business News Network, CBC, Fox Television and RT Television. He speaks six languages and reads another five, skills he uses to provide a more global perspective. Edward holds an MBA in Finance from Columbia University and a BA in Economics from Dartmouth College. Edward also writes a premium financial newsletter. Sign up here for a free trial.

1 Comment

  1. Anonymous says:

    Considering the quality of the assets that the Fed took as collateral at various stages of the crisis it would not surprise me that the Federal Reserve is itself technically insolvent as a consequence of its toxic assets.

  2. DavidLazarusUK says:

    Considering the quality of the assets that the Fed took as collateral at various stages of the crisis it would not surprise me that the Federal Reserve is itself technically insolvent as a consequence of its toxic assets.