The TAF and the Fed's Exposure to Risk

Is the Fed, through it's operation of the Term Auction Facility, bailing out banks and assuming too much risk by accepting financial assets of questionable quality as collateral against loans?

Fed Isn't Getting Snookered by Collateral Risk, by Caroline Baum, Commentary, Bloomberg: Ever since the Federal Reserve created a Term Auction Facility ... to ease the strains in the interbank-lending market, the TAF has been a source of agitation... The thrust ... goes something like this: The Fed, ... printing money at will, is now accepting low-quality collateral as security for 28-day loans to banks whose anonymity is protected. In the process, the central bank assumes credit risk and lays it at the feet of the U.S. taxpayer.

Maybe it's time to take a look at some of the facts.

[Q: Why is the TAF needed?]

[A:]The Fed had already taken steps in August to encourage banks to borrow directly from its discount window... [But...] No matter how nicely the Fed asked, banks were unwilling to incur the stigma associated with discount window borrowing ... at a time when ... any intimation of trouble could cause depositors to take flight. ...

Q: What does a bank have to do to qualify for a loan from the Fed?

A: Banks must be in sound financial condition... They must file the necessary documentation... And they have to pledge collateral...

Q: What sort of securities and loans will be accepted as collateral outside of the traditional U.S. Treasury and agency securities?

A: Corporate and municipal bonds, money-market instruments, asset-backed securities, collateralized-mortgage obligations and various consumer, commercial and industrial, agricultural, residential and commercial real-estate loans.

Q: How does the Fed determine how much to lend against the securities and loans it accepts as collateral?

A: A table of recommended margins for various types of collateral is posted on the Fed's Web site. The Fed lends only a percentage of the market value of the collateral, with the ''haircut'' ranging from 2 percent on short-term, top-quality Treasuries (in other words, the lendable value of a two-year Treasury note is 98 percent) to 40 percent for certain types of consumer loans. ...

If there is no market price for a given security and the discount-window officers and/or bank-supervisory officials at the Fed aren't confident about the value, they can impose a bigger haircut. Alternatively, they can just say no. ...

Q: What happens if the value of the underlying collateral takes a dive during the 28-day term of the loan?

A: The same thing that happens in the private sector: the borrower gets a margin call. If the value of the collateral deteriorates, the Fed can consider other collateral ... Or the Fed bank can immediately reduce the amount of the loan. ... The Fed monitors the collateral on a daily basis. Borrowers that qualified for a loan can un-qualify quickly if the collateral is inadequate.

Q: So you're saying there's nothing to worry about?

A: There's plenty to worry about, including the collapse of the housing market, early signs of decay in commercial real estate, soaring commodity prices, an over-leveraged consumer, losses and potential capital impairment at financial institutions and an economy that's flat-lining. That's enough to keep you up at night without tossing and turning over the Fed's exposure to credit risk.

Comments

[Is the Dollar Doomed?]

Okay, the loans are collateralized (by stuff foreign savers no longer want to buy). The Fed is still creating additional inflation via this process. The Fed does not manufacture any consumer items, and sell them on the open market to earn money to auction off. The Fed creates money out of thin air, and auctions it off. The process still reduces the purchasing power of extant dollars. None of what Caroline wrote will reassure conspiracy theorists that the dollar is not doomed. The dollar continues to lose ground against foreign currencies, and that ancient fall back money gold.

says...

I crap in a bucket and try to sell it. Amazingly nobody wants to buy it. I need some money fast and somebody is willing to lend me boatloads of money using the bucket of crap as collateral (it *is* worth something after all I guess). The interest rate of the loan is lower than the going rate. The lender is willing to do this over and over again. Is the lender here losing out?

Who is losing out when the Fed does what it did today? Nobody? Tax payers?

Ponzi Q. Globalization

says...

I crap in a bucket and try to sell it. Amazingly nobody wants to buy it. I need some money fast and somebody is willing to lend me boatloads of money using the bucket of crap as collateral (it *is* worth something after all I guess). The interest rate of the loan is lower than the going rate. The lender is willing to do this over and over again. Is the lender here losing out?

Who is losing out when the Fed does what it did today? Nobody? Tax payers?

Ponzi Q. Globalization

[ddt]

"Q: Some of the collateral the Fed is accepting is exactly what got the banks into trouble. Why will the Fed do a better job of managing risk when it missed the bad-loan problems at banks it regulates?

A: The discount-window officers at the 12 Federal Reserve District Banks have discretion in determining both the fair value of the collateral and the required margin.

If there is no market price for a given security and the discount-window officers and/or bank-supervisory officials at the Fed aren't confident about the value, they can impose a bigger haircut. Alternatively, they can just say no.

In the current environment, it's safe to say the Fed has been erring on the side of too much rather than too little collateral."

I don't find this particularly reassuring. Isn't the author just engaging in speculation here in assuming that the Fed can accurately value the collateral and will err on the side of caution? What I would like to know is whether or not collateral that now trades in illiquid markets and is therefore impossible to price is being accepted. I don't think that the Fed should be taking on Citibank collateral that is priced at "a reasonable stab".

[wimpie]

"Bernanke said in a speech to bankers in Orlando, Florida, today. ``Principal reductions that restore some equity for the homeowner may be a relatively more effective means of avoiding delinquency and foreclosure.''

Sounds like the PPT is in panic mode. Don't want the sheeple to just "walk away"

youwalkaway.com

[Ken Houghton]

Citi's collateral is certainly a "stab" (cue R. Montalban's Khan in ST, quoting the Greatest Poet Ever).

Let's see: I can go to the Open Market, or I can go to the Fed. The Fed posts the rates and levels--and only takes at most a 40% haircut for TAF "assets," many of which aren't worth half their face value.

But there's nothing going on with TAF.

Caroline Baum usually knows better; that she's willing to publish this piece tells us more than I wanted to know about the severity of the situation.

[johnchx]

The pre-occupation with the valuation of collateral pledged against TAF loans seems to reflect a pretty basic misunderstanding about how the TAF works. Many people seem to imagine that the TAF functions like a "non-recourse" loan (like mortgages in some states) -- i.e. that a bank could "walk away" from its obligation to repay its TAF loan by merely surrendering the collateral...a sort of "banker's jingle mail."

But the premise is false: TAF loans, modeled on loans at the discount window, are full-recourse. If a bank neglects to repay a loan, the Fed can seize pretty much any asset it can lay its hands on (including the bank's reserves on deposit). And the bank itself is out of business. So the relevant information is not the value of individual pieces of collateral but the overall financial position of the borrowing bank.

Can the Fed evaluate the health of individual banks better than "the market" (i.e. other banks)? I think the answer is probably yes, for two reasons.

First, the Fed -- in its regulatory role -- has essentially unfettered access to a bank's financial information, no matter how "proprietary." (Remember, a bank borrowing in the inter-bank market is basically borrowing from its competitors. There are limits to what a bank will disclose to other private entities.)

Second, one of the reasons government can play a role in macroeconomic stabilization at all is that it spooks less easily than private investors. Its job is to keep its head when all around it are losing theirs. So, when periodic panic sweeps this or that market (including the inter-bank credit market), a government agency -- supposedly and hopefully less affected by irrational terror -- will make better judgments about risk than private players in the grip of a panicky stampede for the exits.

[ddt]

"johnchx says...

But the premise is false: TAF loans, modeled on loans at the discount window, are full-recourse. "

Ah, OK. Thanks for that.

[billy]

First, the Fed -- in its regulatory role -- has essentially unfettered access to a bank's financial information, no matter how "proprietary."

So you are saying the Fed knew all about the SIV, VIE and other off-balance sheet rackets by the banks all this time? And yet failed to do anything about it till it started to come crashing down?

[Spectator]

If it walks, talks, and smells like a bailout, it is a bailout. Many have lost trust in Helicopter Ben and his apologists to protect the value of our money. The Fed see no cost to these bailouts - fat chance they will exercise good judgment.

So, when periodic panic sweeps this or that market (including the inter-bank credit market), a government agency -- supposedly and hopefully less affected by irrational terror -- will make better judgments about risk than private players in the grip of a panicky stampede for the exits.

What markets will the Fed backstop? Are they going to help out again when Google stock takes a hit when they first declare a loss. These clowns have no clue what moral hazard is!

[Anon]

Billy,

The Fed did know about SIVs, ABCP conduits and other VIEs. The idea was that off balance sheet entities worked to reduce risk in the banking sector. I think that in retrospect everybody would agree that this process did not work as expected.

[johnchx]

billy asks:

So you are saying the Fed knew all about the SIV, VIE and other off-balance sheet rackets by the banks all this time? And yet failed to do anything about it till it started to come crashing down?

Yes. Correct on both counts.

And you can count me as a vote for the "regulators bungled the job" account of the crisis.

BTW, it's important to know that the whole SIV business was never a secret. Everyone in the industry (and the regulatory agencies and Congress) knew what was going on. Indeed, there was a particularly revealing clue back when Sarbanes-Oxley was being debated: who was the loudest objector to the proposal to increase the outside capital requirements for off-balance sheet entities? Yep...the banking industry.

Off-balance sheet entities are a bit like the accounting loophole that allowed businesses to avoid expensing stock options on their incomes statements: everyone knows that they are transparently fraudulent, but those who profit by them have sufficient clout in Congress to prevent reform (until the crisis strikes, at least).

So the natural question is whether we should trust the regulators who failed to call a halt to the whole off-balance-sheet sock-puppet charade to responsibly manage the crisis.

First, I'd point out that some of the faces really have changed. Ben Bernanke != Alan Greenspan. They really are quite different.

Second, I'd add that Bernanke's critics mostly aren't freaking out about banking regulation at all. They're upset about the fact that the Fed hasn't allowed the commercial banking sector to implode. Note to everybody who thinks that it would be a good idea for commercial banking to collapse in order to teach somebody-or-other a lesson: STFU. Really. We are not going to stage a replay of the Great Depression to satisfy your peculiar obsession with "sound money," or whatever you're on about. Jeez.

Now let's talk about moral hazard. The worry seems to be that providing temporary liquidity to a bank can somehow keep an insolvent institution afloat. This is frankly Ben Stein-level thinking. You see, an insolvent institution cannot become solvent by borrowing money, from the Fed or from anybody else. The only thing that can make an insolvent institution solvent is raising capital. Now, Ben Stein may think that a bank's capital and its reserves are the same thing, but surely nobody here is susceptible to that confusion.

Bottom line: yes, the Fed, along with the Treasury, Congress, the SEC and FASB all bungled the job of financial regulation. No, the remedy for that isn't setting off a wave of failures of illiquid but solvent banks; that is crazy troll logic.

[johnchx]

Spectator asks:

What markets will the Fed backstop?

Umm...the inter-bank market for loaned reserves, the same as usual.

BTW, a little quiz for the critics worried that "helicopter Ben" has been printing too many greenbacks: by exactly how much has the Fed increased the monetary base since the beginning of the crisis (say, since the end of July, 2007)?

[billy]

Bottom line: yes, the Fed, along with the Treasury, Congress, the SEC and FASB all bungled the job of financial regulation.

The first thing to do then would be for all these institutions to admit this. There is a big difference between something being known by everyone, and something being stated in public and acknowledged. The former allows denial to continue and permits resistance to change, the latter allows reform to happen. It is similar to addiction.

No, the remedy for that isn't setting off a wave of failures of illiquid but solvent banks; that is crazy troll logic.

This is a strawman argument. (that is, assuming you can determine the solvency vs. illiquidity question - what is all those structured instruments really worth? )

All that is being debated is the modalities of the bailout. Failed banks should be allowed to fail, and _then_ taken over by the government and bailed out. Stockholders and execs should get zilch. No golden parachutes, no stock with value, no pensions, nothing.

No more Countrywides and Mozillos. If at all there is a bailout, it should be Northern Rocks. The BAC takeover may be private, but it just muddles and dilutes responsibility for the eventual bailout. What would have been a clearcut question(A Countrywide bailout? ) gets converted to a difficult and abstract question ( Saving banking? ). This just protects the racketeers.

I'd point out that some of the faces really have changed. Ben Bernanke != Alan Greenspan. They really are quite different.

I would put a different test. More of Countrywide? then Ben Bernanke = Alan Greenspan.
We shall see.

[Spectator]

Bottom line: yes, the Fed, along with the Treasury, Congress, the SEC and FASB all bungled the job of financial regulation. No, the remedy for that isn't setting off a wave of failures of illiquid but solvent banks; that is crazy troll logic.

You're the one who's crazy. One definition of insanity is doing the same thing over and over and expecting different results. What makes you think regulation will work next time. Wall Street can run circles around the fools at the Fed.

The bank execs who oversaw the worst excesses are walking away with 100s of millions and you call that a solution? The companies should be bankrupt and unable to pay them a dime. That's the only solution. All this concern for the economy is misplaced. That's what the FDIC is for, to protect the prudent. Not to bailout these thugs whose bluff the Fed does not have the courage to call.

[ddt]

"No, the remedy for that isn't setting off a wave of failures of illiquid but solvent banks; that is crazy troll logic. "

I think the argument is that the TAF enables banks to remain solvent by allowing them to avoid marking the assets to reality. I don't think anyone wants illiquid institutions to fail, but they do want insolvent institutions fail rather than prolonging their existense by looking the other way while waiting for the assets to recover, Japan style.

If you have a lender of last resort who is willing to continuously take your bad assets as collateral on short term loans, what is the impetus to sell the bad assets or raise capital? Isn't that the reason the discount window is public and has a stigma attached to it?

[johnchx]

ddt writes:

I think the argument is that the TAF enables banks to remain solvent by allowing them to avoid marking the assets to reality.

Yes, I think that is the perception. But it is (a) mostly not true and (b) not terribly important.

First of all, whether or not the Fed has accepted an asset as collateral has no effect on the valuation of the asset on the institution's books. And, indeed, the value of many such securities are in fact being written down. That's what those big numbers we're reading in the newspapers are.

What the TAF (and, more directly, discount window lending) may do is relieve some institutions of the need to actually sell some securities at a time when the market for them has essentially vanished. But it's very important to note: this vanishing doesn't mean that all CDOs, etc., are worthless; it means that market participants have realized that they don't know what their values are. That's a very different proposition. Being forced to sell into such a "frozen" market isn't marking to reality...it's marking to far below reality. Probably. Of course, the whole problem is that some of the securities in question really are worth little or nothing, but nobody knows exactly which ones. And, under the circumstances, it's perfectly rational to assume that the one that someone is trying to sell you probably is one of the "toxic" ones, because that's why they want to sell it to you. That is, we've got a "market in lemons."

So, in the absence of an active secondary market, these securities are being re-valued on balance sheets based on second-hand indicators, like indexes of credit default swap prices. Interestingly, there's some reason to suspect that the CDS indexes are causing structured-finance securities to be undervalued, and that banks are happily recording losses in 2007-Q4 (and blaming "that fired guy" for the problem), secure in the knowledge that, when markets return more-or-less to normal (in six months to two years), they'll be able to book nice "free" profits from reversing the under-valuation. But that's a topic for another day.

Again, the main point: getting a security accepted as collateral doesn't affect the rules for valuing it.

But suppose it did...would it matter? Not much. I think there's some misunderstanding about the scale of the TAF compared with the scale of the banking industry. At the moment, the TAF is $60 billion. Total. That means that the entire TAF, if it were devoted 100% to purchasing assets with zero fair value, could improve the balance sheet of the banking industry by $60 billion. But the FDIC tells us that the institutions it insures have equity capital totaling over $1.3 trillion. The industry's assets include about $2 trillion in securities and $4.8 trillion in real estate loans. The TAF just isn't big enough to materially affect the solvency of the industry.

[Spectator]

That's right, 60 billion is not enough. Hence the con game and bailout continues. 60B was enough to avoid the admission that bank reserves have gone negative. Without TAF the sham could not continue.

The bald-faced Paulson has the gall to say he does not believe in bailouts. Guess he means bailouts for the poor, but bank bailouts are fine. Only a matter of time before all sensible people realize they've been had. By Wall Street with the active support of the Fed. I don't blame the politicians, since we all know what to expect from them. It's the clueless academics at the Fed that caused this.

[johnchx]

Spectator writes:

Hence the con game and bailout continues. 60B was enough to avoid the admission that bank reserves have gone negative.

Errrr...bank reserves have gone negative? Really? Care to explain how that might be possible? I'm quite curious to know what you think bank reserves are.

[ddt]

" The TAF just isn't big enough to materially affect the solvency of the industry."

Good point. I was unaware of the total size of the TAF, and yes $60 billion is clearly too small to make up for the 500 billion to $1 trillion in losses that is being projected. I'm not sure I agree that the banks have already undervalued their assets, but as you say thats a topic for another day.

says...

From Baum's Feb 8 piece:

"What's caused the hullabaloo recently is the dive in non-borrowed reserves from $44 billion in early December to minus $8.8 billion at the end of January.

It isn't a mystery what happened. The Fed announced the creation of a Term Auction Facility on Dec. 12, enabling banks to borrow for 28 days versus a wide range of collateral. The minimum bid the Fed accepts is the expected funds rate one month out, which in the current environment means cheaper funding costs than the fed funds market.

So what would you do if you were a bank?

Lower Cost Loans made through the TAF are categorized as borrowed reserves. The Fed had $50 billion of loans in place at the end of January, which "caused the borrowed reserves figure to balloon and the non-borrowed figure to decline by a corresponding amount,'' said Lou Crandall, chief economist at Wrightson ICAP LLC in Jersey City, New Jersey, in a Feb. 6 commentary"

[Spectator]

Baum is trying to put lipstick on pigs. Per the NY Times, "Under the program [TAF], banks have been able to borrow money for up to a month or so, pledging collateral that includes mortgage-backed securities, even if the securities are not tradable in today’s markets."

And Baum claims the Fed can value this toxic waste? The only thing we can be sure of is that Wall Street's finest are taking the suckers at the Fed to the cleaners.

This is a fat-cat bailout. The reckless banks are being bailed out, and we're being robbed via currency debasement. So far it appears the Fed drained money elsewhere to compensate, but watch the GSE/FHA balance sheets for the monetization portion of this hidden theft. And that's without what they've done to our savings account earnings.

[groucho]

Spec, haven't u heard the phrase "live by the print, die by the print"?