During the financial crisis, the Federal Reserve resorted to
extraordinary meta-monetary measures. On March 11, 2008, the Fed announced an expansion of
its
securities
lending program and arranged the Term Security Lending Facility (TSLF)
to
provide secured loans collateralized with Treasury securities to the 18
primary
dealers for 28 day terms.
On the same day, the Federal Open Market Committee (FOMC) authorized
increases in its existing temporary reciprocal currency arrangements
(swap
lines) with the European Central Bank (ECB) and the Swiss National Bank
(SNB). These arrangements provided dollars in amounts of
up to
$30 billion and $6 billion to the ECB and the SNB, respectively,
representing
increases of $10 billion and $2 billion. The FOMC extended the
term of
these swap lines through September
30, 2008
Under this new TSLF, the Fed would lend up to $200 billion
of Treasury securities to primary dealers for a term of 28 days
(rather
than overnight, as in the existing program) secured by a pledge of
other
securities,
including federal agency debt, federal agency
residential-mortgage-backed
securities (MBS), and non-agency AAA/Aaa-rated private-label
residential
MBS. The TSLF was intended to promote liquidity in the financing
markets
for Treasury and other collateral and thus to foster the functioning of
financial
markets more generally. As was the case with the current
securities
lending program, securities would be made available through an auction
process. Auctions were held on a weekly basis, beginning on March 27, 2008. The
Fed consulted
with primary dealers on technical design features of the TSLF to fit
their
funding needs.
TSLF was a weekly loan facility that promoted liquidity in
Treasury and other supposedly high-rated collateral markets and thus
fostered
the functioning of financial markets more generally. The program
offered
Treasury securities held by the System Open Market Account (SOMA) for
loan over
a one-month term against other program-eligible general collateral. Yet
the
qualifying credit ratings of the acceptable collaterals were mostly
based on
mark-to-model, since primary dealers holding of high-rated collaterals
mark-to-market
had no need to borrow from TSLF. Securities loans were awarded to
primary
dealers based on a competitive single-price auction. Obviously, primary
dealers
in deepest stress would bid the highest single-price for loans.
The TSLF was announced on March
11, 2008, and the first auction was conducted on March 27, 2008. The TSLF was
closed almost
two years later on February 1,
2010,
but the Fed said it may resume if market conditions warrant. By market
conditions, the Fed meant when a gap again develops between
mark-to-market
values and mark-to-model values that creates distress for primary
dealers. Thus
TSLF was really a facility to support primary dealers on more than
liquidity
distress.
The SOMA Securities Lending program offers specific Treasury
securities held by SOMA for loan against Treasury GC (general
collateral repos)
on an overnight basis. Dealers bid competitively in a multiple-price
auction
held every day at noon. The
TSLF
would offer Treasury GC held by SOMA for a 28-day term. Dealers would
bid
competitively in single-price auctions held weekly and borrowers would
pledge
program-eligible collateral.
In contrast to the Term Auction Facility (TAF) which offered
term funding to depository institutions via a bi-weekly competitive
auction,
the TSLF offered Treasury GC to the New York Fed’s primary dealers in
exchange
for other program-eligible collateral. The New York Fed term repo
operations are designed to temporarily add reserves to the banking
system via
term repos with the primary dealers. These agreements are
cash-for-bond
agreements and have an impact on the aggregate level of reserves
available in
the banking system. The security-for-security lending of the TSLF,
however, would
have no impact on reserve levels since the loans were collateralized
with other
securities. Primary Dealer Credit
Facility (PDCF)
On March 16, 2008,
invoking authority under the rarely used Section 13(3) of the 1932
Federal
Reserve Act, the Fed established temporarily the Primary Dealer Credit
Facility
(PDCF) to provide allegedly fully secured overnight loans to primary
dealers. Primary dealers are banks and securities
brokerages that trade in US Government securities with the Federal
Reserve
System. As of September 2008, there were 19 primary dealers. Daily average trading volume in US Government
securities by Primary dealers was approximately $570 billion during
2007. PDCF
was an overnight loan facility that provided funding to primary dealers
in
exchange for any tri-party-eligible collateral and was intended to
foster the
functioning of financial markets more generally.
PDCF differed from other Fed facilities in the following
ways. The Term Auction Facility program (TAFP) offered term funding to
depository institutions via a bi-weekly auction, for fixed amounts of
credit.
The Term Securities Lending Facility (TSLF) was an auction for a fixed
amount
of lending of Treasury general collateral in exchange for Open Market
Operations (OMO)-eligible and investment grade (AAA) corporate
securities,
municipal securities, mortgage-backed securities, and asset-backed
securities.
Fed credit advanced to the primary dealers under the PDCF
increased the total amount of bank reserves in the financial system, in
much
the same way that Discount Window loans do. To offset this increase,
the OMO
Desk utilized a number of tools, including, but not necessarily limited
to,
outright sales of Treasury securities, reverse repurchase agreements
(reverse
repos), redemptions of Treasury securities and changes in the sizes of
conventional reverse repo transactions.
But PDCF credit differed from discount window lending to
depository institutions in a number of ways. The discount window
primary credit
facility offers overnight as well as term funding for up to 90 calendar
days at
the primary credit rate secured by discount window collateral to
eligible
depository institutions. The primary credit facility at the discount
window, as
revised by the Federal Reserve in 2003, offered credit to financially
sound
banks at a rate100 basis points above the Federal Open Market
Committee’s target
federal funds rate (the primary credit rate).
Primary credit was made available to depository institutions
at an above-market rate but with very few administrative restrictions
and no
limits on the use of proceeds. Because the interest rate charged on
primary
credit was above the market price of funds, it replaced the rationing
mechanism
for obtaining funds from the central bank and eliminated the need for
administrative review by the Federal Reserve.
Amid the onset of the liquidity crisis in August 2007, the Federal
Reserve lowered the spread between the primary credit rate and the
target funds
rate from 100 basis points to 50 basis points and extended the maximum
term of
loans to thirty days.
In March 2008, the Fed once again narrowed the spread, this time
to 25 basis points, and extended the loan term to 90 days. The moves
were
motivated by the desire to make discount window credit more accessible
to
depository institutions.
The Fed’s actions led to an increase in the volume of
discount window borrowing during the crisis. While the massive increase
in the
volume of borrowing supports the argument that the stigma of borrowing
had been
eliminated, one should be cautious when interpreting this result.
Despite the expansion
in borrowing, some trades in the funds market took place at rates above
the
primary credit rate.
Reluctance of banks to borrow from the Fed discount window has
several components. The non-price mechanism is the component
attributable to
the Fed’s implementation of discount lending. This component declined
significantly after the establishment of the revised facility in 2003.
Meanwhile, a second type of stigma arises from the
asymmetric information problems associated with discount window
borrowing.
Specifically, while most banks borrow from the discount window, the
facility is
also used by troubled or failing institutions. Because market
participants
cannot fully differentiate sound from troubled borrowers, they may view
borrowing as a potential sign of weakness of any bank that visits the
discount window.
If this type of stigma increases at the early stages of a financial
crisis,
when institutions are trying to signal their good health, it could
explain the
spikes in the funds rate over the primary credit rate. In addition, it
is
plausible that the capital crunch during the financial crisis left some
institutions without sufficient collateral to apply for primary credit
loans
and thus forced them to bid for higher rates in the federal funds
market, which
is un-securitized.
The PDCF, by contrast, was an overnight facility available
to primary dealers (rather than depository institutions). PDCF expired
on February 1, 2010.
Since not all primary dealers are depository institutions,
the Fed, to provide credit assistance to them, had to invoke authority
under
Section 13(3) of the 1932 Federal Reserve Act, as amended by the
Banking Act of
1935 and the FDIC Improvement Act of 1991, which permits the Fed to
lend to any
individual, partnership, or corporation “in unusual and exigent
circumstances
if the borrower is “unable to secure adequate credit accommodations
from other
banking institutions.”
Section 13(3) was enacted in 1932 out of concern that
widespread bank failures would make it impossible for many firms to
obtain
loans, thus depressing the economy. In the four years after the Section
was
added, the Fed made a total of 123 loans totaling just $1.5 million.
Section 13
(3) was not used again until 2008, 76 years later.
In addition to applying Section 13(3) to PDCF, the Fed also
invoked it to authorize the NY Fed to lend $29 billion to a newly
created
special limited liability corporation named Maiden Lane, LLC) to
exclusively
facilitate the Fed/Treasury-sponsored JP Morgan Chase acquisition of
Bear
Stearns which faced imminent insolvency from bad investments in
subprime
mortgage securities extensively funded by overnight repos that were
unable to
rollover.
The PDCF and the Maiden Lane
loan departed significantly from the Fed’s normal practice of lending
only to
financial sound institutions against top-rated collaterals.The departure was again made when the NY Fed
was granted authority to lend to Fannie Mae and Freddie Mac to
supplement the
Treasury’s moves to stabilize these government sponsored enterprises
(GSEs). As
it turned out, the Treasury had to place both GSEs under
conservatorship in
September 2008.
Nevertheless, a brave new world of central banking began
with these new authorities by the Fed to make unconventional loans
against
toxic assets. Besides TARP programs, mortgage financiers Fannie Mae and
Freddie
Mac have received more than $125 billion in federal aid. There is no
indication
that either firm will be able to repay the government anytime soon, if
ever.
In March, 2008, J. P. Morgan Chase had been provided with a
$29 billion credit line from the Fed discount window in its purchase of
Bear
Stearns arranged by the Treasury. In early September, the Treasury
seized
control of two troubled government sponsored enterprises (GSE) Fannie
Mae and
Freddie Mac with a $200 billion capital injection against a $4.5
trillion
liability, concurrent with another government arranged “shotgun
marriage” that
induced Bank of America to acquire Merrill Lynch at a fire sale price
of $50
billion.
The Paulson Treasury had been criticized and had become
sensitive to criticism of bailing out private Wall Street firms that
should
have been allowed to fail from irresponsible market misjudgments and
Henry
Paulson was eager to show that going forward it was not government
policy to
increase moral hazard. Lehman Bankruptcy
Lehman Brothers’ bankruptcy filing on September 15, 2008 was the result of failure of
the coordinated efforts by the Bernanke Fed and the Paulson Treasury to
find a
qualified buyer for the failing firm. At the end, the refusal of the
Bank of
England to approve the participation of Barclay was a bridge too far in
a
desperate campaign to save Lehman. Secretary Paulson, sensitive to
criticism of
distorting markets for having bailed out Merrill Lynch, resisted
pressure to
bailout Lehman. Alan Meltzer, professor of political economy at CarnegieMellonUniversity
and the respected author of A History of
the Federal Reserve, argued that allowing Lehman to fail was “a
major error
that deepened and lengthen the current recession.”
Bernanke, while defending the Fed’s inaction by citing a
technical legal restraint on Fed lending without adequate collateral,
which
Lehman did not have in relations to its funding needs, admitted on
public
television afterwards that “Lehman proved that you cannot let a large
internationally active firm fail in the middle of a financial crisis.”
He might as well have added you also cannot bailout a large
internationally active firm without long-term effects on market
operations with
penalties for the economy. By now, it is becoming clear that the
difference
between government bailouts and no-bailouts is not different levels of
economic
pain, but how the pain will be borne over time and by whom – those who
were
responsible for the crisis, or innocent taxpayers. Once those
responsible for
the crisis were allowed to escape with no penalty, no reform can
prevent
replays of the crisis.
Within hours of the Lehman bankruptcy filling, the Fed was
confronted with the imminent failure of the American International
Group (AIG)
from exposure to thefailure of the subprime mortgage market through its
underwriting of credit default swaps insurance and other derivative
contracts
and portfolio holdings of mortgage-backed securities. All concerns of
moral
hazard went out the window as the Bernanke Fed and the Paulson Treasury
panicked and opened the door to save dysfunctional market capitalism by
replacing it with state capitalism. The pain was relieved by putting
the
patient in a coma. AIG Bailout
Determining that AIG was too big to fail, the Federal
Reserve Board on September 16 announce that “in current circumstances,
a
disorderly failure of AIG could add to already significant levels of
financial
market fragility and lead to substantially higher borrowing costs,
reduced
household wealth and materially weaker economic performance,” to
justify
invoking Section 13(3) of the Federal Reserve Act to make an $85
billion loan
to AIG, secured by the assets of AIG and its subsidiaries.
In the course of two days, The Fed took different approaches
in dealing with imminent failure of two major institutions, both of
which were
not depository institutions and therefore not qualified for funding
support
through the Fed’s normal lending programs.
In Lehman, the Fed determined it did not have the legal
authority to prevent its failure and also even if with legal authority,
Lehman’s net asset was not inadequate collateral for its funding needs.
The Fed
then concentrated on limiting the impact on other financial firms and
markets.
The Fed was able to protect some large institutions that were
counterparties to
Lehman positions, but it did nothing to protect the general public
around the
world who invested in allegedly high rated Lehman bonds without the
benefit of
full disclosure.
In AIG, the Fed deemed a rescue necessary to protect the
financial system and the economy enough to invoke Section 13(3).The Fed has been widely criticized for not
rescuing Lehman when efforts to find a buyer for it failed, allegedly
resulting
in a deepening and lengthening the consequent recession.Yet the bailout of subsequent distressed
firms did not prevent the recession. Reserve Primary Fund
Broke the Buck
The Lehman bankruptcy did produce immediate fallouts. On September 16, 2008, one day
after the
bankruptcy filing, a major money market fund, Reserve Primary Fund,
with $62
billion under management, announced that the net asset value of its
unit share
has fallen below the required $1 level because of losses incurred o the
fund’s
holdings of Lehman commercial paper and medium term notes. Money market
funds
are supposed to be super safe. They can yield near zero returns but
they are
not supposed to lose principal.
The news of Reserve Primary Fund “breaking the buck”
triggered widespread withdrawal from other money market funds, creating
a
system wide run on the money markets. This prompted the Treasury to
announce a
temporary program to guarantee investment in participating money market
funds. Asset-Backed
Commercial Paper Money Market Mutual Fund Liquidity Facility
The Fed responded to the run of money market funds by again
invoking Section 13(3) to establish the Asset-Backed Commercial Paper
Money
Market Mutual Fund Liquidity Facility (AMLF) to extend non-recourse
loan to US
depository institutions and bank-holding companies to finance purchases
of
asset-backed commercial paper from money market mutual funds. A
non-recourse
loan is ultimately guaranteed only by the collateral pledged for the
loan and
not other assets of the borrower.
On September 21, 2008,
the Fed approved the applications of Goldman Sachs and Morgan
Stanley, both non-deposit-taking institutions, to become bank-holding
companies
and authorized the NY Fed to extend credit to the broke-dealer
subsidiaries of both
firms.
A few days later, the Fed increased its swap lines with the
European Central Bank (ECB) and several other central banks around the
world to
supply additional dollar liquidity in the international market. Commercial Paper
Funding Facility (CPFF)
Yet, financial market turmoil continued in the ensuing weeks
despite the massive bailout programs. To revive the stalled commercial
paper
market, the Fed invoked again Section 13(3) to introduce the Commercial
Paper
Funding Facility (CPFF) on October
7, 2008. This facility provided financing for a
special-purpose
vehicle established to purchase 3-month unsecured and asset-backed
commercial
paper directly from eligible issuers.
In recent decades, the commercial paper (CP) market has
become an important part of the financial system as an alternative
source to
bank loans for lower-cost short-term financing. In recent years, the CP
market
has become dominated by financial issuers rather than industrial
issuers. Large
investors purchase CP directly while small investor purchase through
money
market mutual funds (MMMFs) which intermediate between large
denomination CP
and the liquid, small denomination share issued to retail investors.
The CP
market is now larger than the Treasury bills market.
Large companies, such as GE, can issue their unsecured CP
directly through its finance subsidiary such as GE Capital, or via an
agent or
dealer known as a single-seller conduit. Small firms, to save cost,
prefer to
borrow through a multi-seller conduit in which a small firm sells its
debt to a
bank-advised special purpose vehicle (SPV) which in turn sells
asset-backed
commercial paper (ABCP) to many investors. The ABCP SPV purchases the
debt,
mostly collateralized debt obligations (CDO), at a discount from its
face value
to maintain an over-collateralization (a haircut to the seller of the
debt) to
provide an equity cushion for the investors. CDOs are securitized
instruments
which derive its cash flow from ongoing payments of consumer debt
obligations,
such as credit card obligation, car finance obligations or other
installment
payment obligations.
Because the maturity of the CP is shorter than the maturity
on the underlying loan, the ABCP conduit will roll over the maturing CP
to pay
old investors with money from new investors. Liquidity providers will
provide
funds for a fee in case some CP is not rolled over. To assure
investors,
additional program-wide credit enhancement on the form of bank letter
of credit
at higher interest rate is arranged, but is only drawn upon if needed.Dealers charge clients a fee that is less
than one eighth of 1 percentage point, which in 2008 translated into
roughly
$150 million in daily fees on $120 billion new CP issued daily. Asset-backed
commercial paper (ABCP) and Special Purpose Vehicles (SPV)
Asset-backed commercial paper (ABCP) is CP with specific
assets attached, issued as security by “conduits” that are structured
to be
bankruptcy remote and limited in purpose. Each conduit includes a
“special
purpose vehicle (SPV) that is the legal entity at the center of the
program and
a financial advisor (usually a commercial or investment bank) that
manages the
program and determines the assets to be purchased and the ABCP to be
issued.
The owner of the conduit receives nominal dividend payments. Since the
SPV does
not generally have any employees, fees are paid to an administrator
(normally a
bank) to manage CP rollovers and the flow of funds.
SPVs, especially the more complex ones, are opaque entities
that hold assets undisclosed to the purchaser of their ABCP. For this
lack of
transparency, ABCP generally yield some 75basis point more than
traditional
unsecured CP. The market calculates the spread using rates on AA-rated
CP
reported in the Fed volume statistics on CP issuance. The spread
changes
depending on the issue type, financial or non-financial, and maturity
chosen.
The spread is a mysterious outcome. Why should CP with
specific attached assets as collateral pay a higher yield than CP with
only
general collateral? Moody’s attributed the yield premium to lack of
transparency. As financial intermediaries, CP conduits purchased
financial
assets and issued ABCP under their own name, performing the task of
risk and
rate spread arbitrage between assets they purchased and the liabilities
they
issued. To insure against risk, the conduits bought credit default
swaps (CDS)
from a highly rated insurer such as AIG which collected profitable fee
against
defaults that were not expected to happen. AIG Financial
Products (AIGFP)
AIG Financial Products (AIGFP), based in London
where the regulatory regime was less restrictive, took advantage of AIG
statue
categorization as an insurance company and therefore not subject to the
same
burdensome rules on capital reserves as banks imposed by the Fed or the
FDIC.
AIG would need to set aside only a tiny sliver of capital to insure the
super-senior risk tranches of CDOs (collateralized debt obligations) in
its
holdings. Nor was AIG likely to face hard questions from its own
regulators in New York
because AIGFS had largely fallen through the
interagency cracks of oversight. AIGFS operation in the US
was regulated by the US Office for Thrift Supervision, whose staff had
inadequate expertise in the field of cutting-edge structured finance
products.
AIGFP insured bank-held super-senior risk CDOs in the broad CDS market.
AIG
would earn a relatively trifle fee for providing this coverage – just
0.02
cents for each dollar insured per year. For the buyer of such
insurance, the
cost is insignificant for the critical benefit, particularly in the
financial
advantage associated with a good credit rating, which the buyer
receives not
because the instruments are “safe” but only that the risk was insured
by AIGFP.
For AIG, with 0.02 cents multiplied a few hundred billion times, it
adds up to
an appreciable income stream, particularly if no reserves are required
to cover
the supposedly non-existent risk. Regulators were told by the banks
that a way
had been found to remove all credit risk from their CDO deals. Credit Default Swaps
(CDS)
The
Office of the Comptroller of the Currency and the Federal Reserve
jointly
allowed banks with credit default swaps (CDS) insurance to keep
super-senior
risk assets on their books without adding capital because the risk was
insured.
Normally, if the banks held the super-senior risk on their books, they
would
need to post capital at 8% of the liability. But capital could be
reduced to
one-fifth the normal amount (20% of 8%, meaning $160 for every $10,000
of risk
on the books) if banks could prove to the regulators that the risk of
default
on the super-senior portion of the deals was truly negligible, and if
the
securities being issued via a collateral debt obligation (CDO)
structure
carried a Triple-A credit rating from a “nationally recognized credit
rating
agency”, such as Standard and Poor’s rating on AIG.
With CDS insurance, banks then could cut the normal $800 million
capital for
every $10 billion of corporate loans on their books to just $160
million,
meaning banks with CDS insurance can loan up to five times more on the
same
capital. The CDS-insured CDO deals could then bypass international
banking
rules on capital. To correct this bypass was a key reason why the
government wanted to conduct stress tests on banks in 2009 to see if
banks needed
to raise new capital in a Downward Loss Given Default. Moody’s defines
loss
given default as the sum of the discounted present values of the
periodic
interest shortfalls and principal losses experienced by a defaulted
tranche.
The coupon rate of the tranche is used as the discount rate.
CDS contracts are generally subject to mark-to-market accounting that
introduces regular periodic income statements to show balance sheet
volatility
that would not be present in a regulated insurance contract. Further,
the buyer
of a CDS does not even need to own the underlying security or other
form of
credit exposure. In fact, the buyer does not even have to suffer an
actual loss
from the default event, only a virtual loss would suffice for
collection of the
insured notional amount.
So,
at 0.02 cents to a dollar (1 to 10,000 odd), speculators could place
bets to
collect astronomical payouts in billions with affordable losses. A
$10,000 bet
on a CDS default could stand to win $100,000,000 within a year. That
was
exactly what many hedge funds did because they could recoup all their
lost bets
even if they only won once in 10,000 years.
As it
turns out, many only had to wait a couple of years before winning a
huge
windfall and driving AIG into insolvency in the process. But until AIG
was
bailed out by the Fed, these winning hedge funds were not sure they
could
collect their winnings. Lucky for the winning hedge funds, the Fed, by
bailing
out AIG, paid them in full. (Please see my June 24, 2009AToL
article: Greenspan
Characterized Regulatory Arbitrage as Desirable) Money Market Investor Funding Facility
(MMIFF)
On October 7, 2008,
Section 13(3) was also invoked by the Fed to create the Money Market
Investor
Funding Facility (MMIFF) under which the Fed offered to provide loans
to series
of special-purpose vehicles that purchased assets from money market
mutual
funds and other eligible investors. Special-purpose vehicles were the
venue
that the likes of Enron and Lehman used to hide liabilities from their
balance
sheets. (Please see my January
23, 2009 article: No Exit for Emergency
Nationalization) CitiGroup Bailout
Within a month, on November
23, 2008, Citigroup was the next too-big-to-fail institution
requiring assistance from the government. The Fed participated with the
Treasury and the FDIC in a financial assistance package to provide a
non-recourse loan to support a government guarantee of $300 billion of
real
estate loans and securities held by Citigroup, although the Fed has yet
to be
called upon by Citigroup to make a loan under the agreement. Term Asset-Backed
Security Lending Facility (TALF)
Tow days later, on November 25, 2008, the Fed again invoke
Section 13(3) to create the Term Asset-Backed Security Lending Facility
(TALF)
under which the NY Fed provided non-recourse loans to holders of
Triple-A-rated
asset-backed securities and recently originated consumer and small
business
loans. The TALF was launched on March
3, 2009. The types of eligible collateral were subsequently
expanded on March 19 and May
19, 2009.
Throughout the fall of 2008, the Fed approved more large
financial firms to become bank holding company, including American
Express, CIT
Group, and (General Motors Acceptance Corporation (GMAC) which has
generated
some 60% of General Motors revenue by financing car installment
purchases and
leases, but its main profit in pre-crisis years had been financing
subprime
mortgages. Despite government help, CIT Group eventually filed
bankruptcy
protection while GMAC had to be bailed out by the Treasury. CIT Bankruptcy
CIT Group filed for Chapter 11 bankruptcy protection on November 1, 2009, in an
effort to
restructure its debt while trying to keep loans flowing to the
thousands of
mid-sized and small businesses.
CIT bankruptcy will wipe out current holders of its common
and preferred stock, likely meaning the US
government and taxpayers will lose the $2.3 billion sunk into CIT in
2008 to prop
up the ailing company. Goldman Sachs however, will gain $1 billion
because of
CIT’s bankruptcy, according to a report published October 4 by the Financial Times:
The payment stems from the
structure of a $3 billion rescue finance package that Goldman extended
to CIT
on June 6, 2008,
about five
months before the Treasury bought $2.3 billion in CIT preferred shares
to prop
it up at the height of the crisis...
While Goldman is entitled to demand
the full amount, it is likely to agree to postpone payment on a part of
that
sum, these people added. A CIT filing last week said that it was in
negotiations with Goldman "concerning an amendment to this facility".
The $2.3 billion lost in taxpayer funds is the largest
amount lost since the government began infusing banks with capital,
according
to the Financial Times.
CIT made the filing in New York
bankruptcy court on a Sunday, after a debt-exchange offer to
bondholders
failed. CIT said in a statement that its bondholders have
overwhelmingly
approved a prepackaged reorganization plan which will reduce total debt
by $10
billion while allowing the company to continue to do business to
provide
funding to our small business and middle market customers, two sectors
that
remain vitally important to the US
economy.
The CIT Chapter 11 bankruptcy filing is one of the biggest
in recent US
corporate history. Only Lehman Brothers, Washington Mutual, Worldcom
and
General Motors had more in assets when they filed for protection. CIT’s
bankruptcy filing shows $71 billion in finance and leasing assets
against total
debt of $64.9 billion. Its collapse is the latest in a string of huge
cases
driven by the financial crisis over the past two years, as bailed-out
industry
heavyweights like General Motors and Chrysler both entered bankruptcy
court.
CIT said all existing common and preferred stock will be
cancelled upon emergence from bankruptcy protection. That would likely
include
preferred stock from the $2.3 billion in funding from the government’s
Troubled
Asset Relief Program (TARP) the company received in its efforts to stay
afloat.
CIT sought a second federal bailout in July 2009 but the
request was rejected. It was then able to get a $3 billion loan from
bondholders in order to stave off bankruptcy temporarily.
CIT had been trying to fend off disaster for several months
earlier and narrowly avoided collapse in July, 2009. It has struggled
to find
funding as sources it previously relied on, such as short-term debt
from the
repo market, evaporated during the credit crisis.
CIT had received $4.5 billion in credit from its own lenders
and bondholders a week before filing for bankruptcy, reportedly made a
deal
with Goldman Sachs to lower debt payments, and negotiated a $1 billion
line of
credit from billionaire investor and bondholder Carl Icahn. But the
company
failed to convince bondholders to support a debt-exchange offer, a step
that
would have trimmed at least $5.7 billion from its debt burden and given
CIT
more time to pay off what it owed.
The bankruptcy filing was bad news for small businesses,
many of which look to CIT for loans to cover expenses at a time when
other
credit is hard to come by. Already ailing sectors, such as consumer
goods retailers,
would be hit especially hard, since CIT served as the short-term
financier for
about 2,000 vendors that supply merchandise to more than 300,000
consumer
retail stores. Congressional
Oversight Panel Criticized Fed Handling of GMAC
On March 10, 2010,
the Congressional Oversight Panel (COP) under Elizabeth Warren released
a new
report: The
Unique Treatment of GMAC Under the TARP which also criticizes the
handling
of GMAC under TALF. The Term
Asset-Backed Securities Loan Facility
(TALF) is the name of a program created by the Fed November 25,
2008. It
provided support to the market for asset-backed securities,
such as
those that are backed by auto loans, credit card loans, small business
loans,
and student loans. TALF was closed on March 31, 2010 for loans backed by all types of
collateral except newly
issued commercial mortgage-backed securities (CMBS) and scheduled for
closure
on June 30, 2010
for loans
backed by newly issued CMBS. The Panel
said it remains unconvinced that bankruptcy was not a viable
option in 2008. In connection with the Chrysler and GM
bankruptcies, Treasury might have been able to orchestrate a strategic
bankruptcy for GMAC. This bankruptcy could have preserved GMAC’s
automotive
lending functions while winding down its other, less significant
operations,
dealing with the ongoing liabilities of the mortgage lending
operations, and
putting the company on sounder economic footing.
The
federal
government has so far spent $17.2 billion to bail out GMAC and now owns
56.3
percent of the company.
Both GMAC and Treasury insist that the company is solvent and will not
require
any additional bailout funds, but taxpayers already bear significant
exposure
to the company, and the Office
of Management and Budget (OMB) currently estimates that $6.3
billion or more may never be repaid.
Although
the Panel took no position on whether Treasury should have rescued
GMAC, it
found that Treasury missed opportunities to increase accountability and
better
protect taxpayers’ money. Treasury did not, for example, condition GMAC
access
to TARP money on the same sweeping changes that it required from GM and
Chrysler: it did not wipe out GMAC’s equity holders; nor did it require
GMAC to
create a viable plan for returning to profitability; nor did it require
a
detailed, public explanation of how the company would use taxpayer
funds to
increase consumer lending. Moreover, the Panel remains unconvinced that
bankruptcy was not a viable option in 2008.
In light of the scale of these potential losses, the COP report
expressed deeply concern
that
Treasury has not required GMAC to lay out a clear path to viability or
a
strategy for fully repaying taxpayers. Moving
forward, Treasury should clearly articulate its exit
strategy from GMAC. More than a year has elapsed since the government
first
bailed out GMAC, and it is long past time for taxpayers to have a clear
view of
the road ahead.
And a few recommendations from COP:
• Treasury should insist
that GMAC produce a viable business planshowing
a path toward profitability
and a resolution of the problems caused by ResCap.
• Treasury should formulate, and clearly articulate,a near-term exit strategy
with respect to GMACand
articulate how that exit will or should be coordinated with exit from
Treasury’s holdings in GM and Chrysler.
• To preserve market discipline and protect taxpayer interests,
Treasury should
go to greater lengths to explain
its approach to the treatment of legacy shareholders,
in conjunction with both initial and ongoing government assistance.
This fits with the earlier discussions on the stress tests
since GMAC was on the “Stress Test 19”. It probably would have cost the
taxpayers far less to have GMAC file bankruptcy than the current
situation. Government Takeover
of Government Sponsored Enterprises
On September 7, 2008,
Treasury officials unveiled an extraordinary takeover of government
sponsored
enterprises (GSEs): Fannie Mae and Freddie Mac, putting the government
in
charge of the twin mortgage giants and the $5 trillion in home loans
the GSEs
back.
The move, which extends as much as $200 billion in Treasury
support to the two companies, marks the government’ most dramatic
attempt yet
to shore up the nation’s collapsed housing market to try to stop record
foreclosures and falling prices. The sweeping plan, announced by
Treasury
Secretary Henry Paulson and James Lockhart, director of the Federal
Housing
Finance Agency, places the two government sponsored enterprises into a
"conservatorship" to be overseen by the Federal Housing Finance
Agency. Under conservatorship, the government would temporarily run
Fannie and
Freddie until they are on stronger footing.
Fannie (FNM)
and Freddie (FRE),
which were created by the U.S.
government, have been badly hurt in the past year of the on-going
crisis by the
sharp decline in home prices as well as rising mortgage delinquencies
and
foreclosures. All told, the two firms have racked up about $12 billion
in
losses since the summer of 2007.
Dividends on both common and preferred shares of Fannie and
Freddie will be eliminated in an effort to conserve about $2 billion
annually.
All lobbying and political activities by the GSEs will be halted
immediately
and charitable activities reviewed.
In addition, the Treasury Department announced a series of
moves targeted at providing relief to both housing and financial
markets.
Paulson said Treasury would boost housing by purchasing mortgage-backed
securities
from Freddie and Fannie, as well as offering to lend money to the
companies and
the 12 Federal Home Loan Banks. The home loan banks advance funds to
more than
8,000 member banks. The Treasury, with fellow regulator FHFA, will also
buy
preferred stock in Fannie and Freddie to provide security to the
companies'
debt holders and bolster housing finance. The government, in agreeing
to
backstop the firms, said it would receive $1 billion in each company's
senior
preferred stock. The government will also receive a quarterly dividend
payment
and the right to own 79.9% of each company.
Shares of Fannie and Freddie, which have fallen more than
80% since the beginning of the credit crisis, had been hammered in the
summer
of 2008 among concerns they would need to raise additional funds to
cover
future losses or need to be taken over by its federal regulator.
Investors
feared that either step would reduce or wipe out the value of current
shareholders’ stakes.
In mid-July, 2008 the Treasury Department and Federal
Reserve announced steps in to make funds available to the firms if
necessary
and Congress approved the sweeping proposals later that month.
Shortly thereafter, regulators stepped up their review of
Fannie and Freddie. Secretary Paulson announced in August that he had
tapped
Wall Street firm Morgan Stanley to help him examine the firms.
Morgan Stanley had determined that both Freddie and Fannie
faced "meaningful" capital issues before deciding that government
intervention was necessary. Officials ruled out a capital infusion - a
less
drastic option than convervatorship - after considering questions such
as
whether the government would have to keep putting money in and how best
Treasury officials could protect taxpayers. In the end, the route taken
amounted
to “a timeout, not a liquidation.” Conservatorship leaves all options
open for
the Obama administration.
Following an exhaustive review, FHFA’s Lockhart said that
the two companies could not continue to operate without taking
“significant
action”. Fannie and Freddie had become virtually the only source of
funding for
banks and other home lenders looking to make home loans. Their ability
to do so
is crucial to the recovery of the battered home market and the broader U.S.
economy.
The two firms buy loans, attach a guarantee, then sell
securities backed by the loans' income stream. All told, they own or
back $5.4
trillion worth of home debt - half the mortgage debt in the country.
The Treasury-FHFA plan, which was widely anticipated after
financial markets closed on Friday, drew praise from regulators,
lawmakers and
some market experts.
President Bush called the move “critical” to the housing
market recovery. “Americans should be confident that the actions taken
today
will strengthen our ability to weather the housing correction and are
critical
to returning the economy to stronger sustained growth in the future,”
he said.
Fed Chairman Ben Bernanke, who along with Paulson has led
efforts to help get the US
housing market and the broader economy back on track, endorsed the move
by
Lockhart and Paulson. “These necessary steps will help to strengthen
the US
housing market and promote stability in our financial markets,”
Bernanke said
in a statement.
Senator Charles Schumer, D-N.Y., a member of the Senate Banking
Committee, said that Paulson had “threaded the needle just right” with
the
plan, noting that it will likely be met with praise from other
lawmakers.
Pimco’s Bill Gross, a widely followed bond fund manager,
said that the Freddie-Fannie plan was the right move. “This is a
significant
step and almost exactly what we had hoped for,” Gross told
CNNMoney.com.
In addition to confirming the government's sovereign credit
rating, Standard & Poor’s affirmed its sterling AAA rating on both
Fannie
Freddie on the news, adding that its outlook for the two firms to be
stable.
At first blush, Wall Street seemed encouraged by the news,
although the true test came when financial markets around the globe
failed to
rally. The cost of the government intervention remained unclear
however.
Experts argue that it will depend in large part on the structure of the
rescue,
the direction of home prices and mortgage default rates.
Still it seems almost certain it will run into the billions
and will most likely eclipse such other high-profile government
bailouts
including than the Fed’s $29 billion backing of Bear Stearns assets
when it was
taken over by J.P. Morgan Chase.
Paulson said that the cost to taxpayers would largely depend
on the future financial performance of Fannie and Freddie. But he
stopped short
of saying that the future appeared rosy. The problem would be handed
over to
his Democrat successor, Timothy F. Geithner.
Another unintended yet unavoidable consequence may be the
adverse impact on the nation’s troubled banks. Some of the nation's
largest
financial institutions including JPMorgan Chase and Sovereign Bancorp
own a big
chunk of the estimated $36 billion in preferred shares of Fannie and
Freddie.
Those stakes are at risk of being wiped out.
Top banking regulators, including the Federal Reserve as
well as the FDIC, said in a joint statement that a limited number of
smaller
institutions have significant preferred share holdings in Fannie and
Freddie.
They added they are prepared to work with these institutions to come up
with a
plan should they need to raise capital.
The government rescue of Fannie and Freddie has so far fall
short of its intended aim - bringing stability to the housing market
while
making it easier for consumers to obtain affordable mortgages.
Foreclosure rate
has not dropped and home sale has remained stagnant. The Issue of Interest
Rates
After the market closed on Thursday, February 16, 2010, the
Fed raised the discount rate, at which banks are charged when they
borrow from
the Fed, by 25 basis points to 0.75%, making it 50 to 100 basis points
higher
than the Fed Funds rate at 0 to 0.25% set 14 months ago on December 15,
2008.
The Fed took pain to draw attention to the distinction
between the discount rate and its target for overnight interbank rates,
called
the Fed Funds rate, its main monetary policy tool. The Fed Funds rate
target
remains unchanged near zero percent, while a still fragile US
economy strains in vain to gain recovery traction to lowering
unemployment and
to increasing consumer demand. The Fed appears powerless in getting
banks,
which are receiving practically free loans form the Fed, to lend into
the
market, particularly to small and medium businesses through which most
new jobs
are expected to be created.
The Fed statement read: “Like the closure of a number of
extraordinary credit programs earlier this month, these changes [of the
discount rate] are intended as a further normalization of the Federal
Reserve’s
lending facilities. The modifications are not expected to lead to
tighter
financial conditions for households and businesses and do not signal
any change
in the outlook for the economy or for monetary policy.”
What the Fed statement conveniently left out was that the
higher discount rate is also not expected to ease still tight financial
conditions for household and businesses.In
other words, raising the discount rate is
largely an empty gesture to
impress the market that the Fed has not forgotten the need to protect
the exchange
value and purchasing power of the dollar. Yet, historical data suggest
that a
return to normalcy of Fed lending facilities can only mean a return to
the
decades of monetary excess represented by the free money regime of the
past two
years.
The discount rate is the interest rate charged to commercial
banks and other depository institutions on loans they receive from
their
regional Federal Reserve Bank’s lending facility--the discount window.
The
Federal Reserve Banks offer three discount window programs to
depository
institutions: primary credit, secondary credit, and seasonal credit,
each with
its own interest rate. All discount window loans are fully secured.
Under the primary credit discount program, loans are
extended for a very short term (usually overnight) to depository
institutions
in generally sound financial condition. Depository institutions that
are not
eligible for primary credit may apply for secondary credit to meet
short-term
liquidity needs or to resolve severe financial difficulties. Seasonal
credit is
extended to relatively small depository institutions that have
recurring
intra-year fluctuations in funding needs, such as banks in agricultural
or
seasonal resort communities.
The discount rate charged for primary credit (the primary
credit rate) is set sometimes above and sometimes below the level of
short-term
market interest rates, depending on the Fed judgment on market
conditions. Because
primary credit is the Federal Reserve’s main discount window program,
the
Federal Reserve at times uses the term “discount rate” to mean the
primary
credit rate. The discount rate on secondary credit is generally above
the rate
on primary credit. The discount rate for seasonal credit is an average
of
selected market rates.
The term “discount rate”, although widely used, is actually an
anachronism. Since 1971, Reserve Bank loans to depository institutions
have
been secured by advances. Interest is computed on an accrual basis and
paid to
the Fed at the time of loan repayment.The
discount rate is important for two
reasons: (1) it affects the cost
of reserves borrowed from the Federal Reserve and (2) changes in the
rate can
be interpreted as an indicator of monetary policy.Increases in the discount rate generally
reflect the Federal Reserve’s concern over inflationary pressures,
while
decreases often reflect a concern over economic weakness or in recent
times,
deflation.
Discount-window lending, open market operations to effect
changes in reserves to set Fed funds rates, and bank reserve
requirements are
the three main monetary policy tools of the Federal Reserve System.
Together,
they influence the cost and supply of money and credit, a major
component in
macroeconomics.
Normally, the discount rate is set lower than the Federal Funds
and other money-market interest rates. However, the Fed does not allow
banks to
borrow at the discount window for profit. Thus, it monitors
discount-window and
Federal Funds activity to make sure that banks are not borrowing from
the Fed
in order to lend at a higher rate in the Federal Funds market.
During periods of monetary ease, the spread between the
Federal Funds and discount rates may narrow or even disappear briefly
because
depository institutions have less of a need to borrow reserves in the
money
market. Under these conditions, the Fed may adjust the discount rate in
order
to reestablish the accustomed spread.
Discount window loans are granted only after Reserve Banks
are convinced that borrowers have fully used reasonably available
alternative
sources of funds, such as the Federal Funds market and loans from
correspondents and other institutional sources. The latter sources
include the
credit programs that the Federal Home Loan Banks and the Central
Liquidity
Facility of the National Credit Union Administration provide for their
members.
Usually, relatively few depository institutions borrow at
the discount window in any one week. Consequently, such lending
provides only a
small fraction of the banking system’s total reserves. All depository
institutions that maintain reservable transaction accounts or
nonpersonal time deposits are entitled to borrow at the
discount window. This includes commercial banks, thrift institutions,
and United States
branches and agencies of foreign
banks. Prior to the passage of the Depository Institutions Deregulation
and
Monetary Control Act of 1980, discount window borrowing generally had
been
restricted to commercial banks that were members of the Federal Reserve
System.
In the course of the current financial crisis, the Fed has allowed
financial
firms, such as Goldman Sachs, to declare themselves as bank holding
companies
to qualify as borrowers at the Fed discount window.
Changes in the discount rate generally have been infrequent.
In the decades from 1980 through 1990, for example, there were 29
discount rate
changes, and the duration of the periods between adjustments ranged
from two
weeks to 22 months. However, following those 22 months without a
change, the
Fed cut the discount rate seven times in the period of economic
sluggishness
from December 1990 to July 1992 -- from 7.0 percent at the start of the
period
to 3.0 percent at the end. From May 1994 to February 1995, when the Fed
was
concerned about the threat of inflation, it raised the discount rate
four times
-- from 3.0 to 5.25 percent.
Changes in the discount rate often lag changes in market
rates. Thus, even though the Fed pushed the Federal Funds rate down 25
basis
points in July 1995, as of December that same year it had not cut the
discount
rate. Since 1980, the changes in the discount rate have been by either
50 or
100 basis points (one half or a full percentage point), although mostly
quarter-point changes were made in earlier years. This reflects the
insensitivity of the money market to discount rate levels. The lowest
discount
rate charged by the New York Fed was 0.5%, which was in effect from
1942
through 1946; the highest rate was 14%, which lasted from May to
November 1981
when the Fed Funds rate was at 20%.
Starting in mid July 1971, the discount rate had been set
below the Fed Funds rate, with a spread of 300 basis points on August 13, 1973 at 7.5%
against a Fed
Funds rate at 10.5%. On February
4, 1975,
the Fed reversed the pattern to set the discount rate at 6.75%, 50
basis points
above the Fed Funds rate target at 6.5%. Generally, when the discount
rate is
set above the Fed Funds rate target, the Fed is punishing banks that
borrow
from the discount level, with the aim of slowing the supply of high
power money
from the Fed.
On August 29, 1977,
the Fed again reversed the pattern to set the discount rate at 5.75%,
25 basis
points below the Fed Funds rate at 6%. The pattern was reversed again
on May
28, 1980 with the discount rate set at 12%, 225 basis points above the
Fed
Funds rate at 9.75%, until September 25 in the same year when the
discount rate
was set at 11%, 100 basis point below the Fed Funds rate at 12%.Since January
25, 2003, when the Federal Reserve System implemented a
“penalty”
discount rate policy, the discount rate has been about 1 percentage
point, or
100 basis points, above the effective (market) Fed Funds rate.
This history showed the high volatility of the money supply
and the unusual swing of the Fed’s intervention in market interest
rates. This
was a departure form the Fed’s traditional preference for gradualism in
interest
rate fluctuation. It told the market that the Fed was repeatedly
over-compensating its earlier overcompensation to produce damagingly
high
volatility in the money supply.
Discount rates are established by each of the six Reserve
Bank’s board of directors, subject to the review and determination of
the Board
of Governors of the Federal Reserve System. The discount rates for the
three
lending programs are the same across all Reserve Banks except on days
around a
change in the rate. The discount rate is not set by the Fed Open Market
Committee (FOMC) which has the authority to set the Fed Funds rate
target to be
implemented exclusively by the New York Fed through buying and selling
treasury
instruments in the repo market. The other eleven regional Reserve Banks
do not
participate in open market operations.
The Fed does not set interest rates directly. The FOMC sets
targets and the Federal Reserve Bank of New York
estimate money supply targets needed to hit those goals by
participating in the
repo market. (Please see my September
25, 2005 AToL article: The Repo
Time Bomb
and December 5, 2009
article: Repo
Time Bomb Redux). The repo market has been a major source of
short-term
funds for financing long-term investments. In recent years, it has also
become
the legal channel to masking institution risk exposure by moving
liabilities
off balance sheet to categorizing the repo transactions as sales rather
than
collateralized loans.
The Federal Reserve is unlikely to make any big changes to
its monetary policy stance in the near-term future, though there is a
chance it
could make some alterations to its provision of liquidity. The Fed is
likely to
keep the key line of its policy guidance – in which it says it expects
to keep
rates at “exceptionally low levels” for an “extended period” –
unchanged.
However, the Fed expectedly announced a decision to increase
the discount rate at which the Fed makes emergency loans to banks,
coupled with
reaffirmation from the Federal Reserve Board that it would shut down
many
emergency liquidity programs on February
1, 2010. This move would tighten financial conditions
slightly at
the margin, but it should not be mistaken for a tightening of monetary
policy.
As the crisis ebbs, the Fed is borrowing a page from the
European Central Bank, which draws a sharp distinction between monetary
policy
and liquidity policy, through a so-called “separation principle”. The
Fed
viewed this distinction as problematic mid-crisis but now it appears to
believe
it has relevance to the exit process. With financial markets once again
buoyant
but the economy still burdened with high unemployment, normalizing
monetary policy
and liquidity policy can be expected to proceed at differing pace.
The approach of the unified end of the financial year caused
the Fed to defer action on liquidity into 2010, which will be the first
time
the former investment banks that became banking holding companies and
the
regular deposit-taking banks share the same December 31 year-end,
making it
impossible for them to shift illiquid assets back and forth to show
strong
year-end positions. Against that accounting convergence, there are more
than $1
trillion excess reserves in the system to smooth over year-end
liquidity
stress.
The Fed amended its key guidance on the outlook for interest
rates for the first time since March 2009. It added that the conditions
on
which this guidance – commonly understood to mean rates near zero for
at least
the next six months – is based. Implicitly in doing so it indicated
what might
lead to rate hikes within the six-month period.
Rather than change this template, the Fed is likely to
update its discussion of the economy in ways that refer to the
conditions. For
instance, it may state that levels of resource utilization have
improved
slightly with the November 2009 employment report, although they remain
low.
Fourth-quarter 2009 growth was 5.7 per cent. However, the Fed will
probably
retain its assessment that inflation is moderate and inflation
expectations
stable.
Fed hawks and doves had been resting on a quiet truce in
2009 while positioning themselves for a fight in mid-2010. With
unemployment
still at 10%, and Congress turning hostile towards the Fed, the
interest rate
hawks are putting on their deficit hawk masks.Yet
excess capacity does not automatically
translate into lowering of
prices, as firms are forced to raise prices for price-insensitive
customers to
offset loss of revenue from price-sensitive customers. The result is
stagflation.
The risk factors that could force an earlier battle on
interest rates between hawks and doves have remained subdue. The
dollar’s
exchange rate has improved from sovereign debt crisis in the EU and
commodity
prices have stabilized for slow demand. Many policymakers are paying
attention
to asset prices and some are uneasy that interest rate guidance is
feeding
speculative trades. But there is a widespread preference for using
regulatory
tools rather than interest rates in the first instance to curb any
emerging
speculative excesses.
Going forward, the Fed’s extraordinary Section 13(3)
Programs will pose a formidable challenge to the Fed’s exit strategy.
The
economy may have to limp along with government help for a whole decade.
