THE DIFFICULTY OF FITTING THE THREAD
THROUGH THE FEDS EYE

by
William Krehm

The Wall Street Journal (20/01, “The Fed is Becoming a conglomerate” by Serena Ng and Liz Rappaport) minces no words: “It has loads of subprime-mortgage bonds, souring commercial real estate, and collateralized debt obligations worth a fraction of their original value. This isnt Citigroup Inc. or Merrill Lynch. It is the Federal Reserve.

“In the past year, the Fed lent out more than $1 trillion in its efforts to stabilize the financial and credit markets. A chunk of that was used to buy mortgage-related securities and loans in the rescues of Bear Stearns Cos. and American International Group Inc., as well as other debt shunned by investors.

“Now, the governments recent aid packages for Bank of America Corp. and Citigroup have the Fed playing the additional role of a backstop guarantor for portfolios of about $400 billion in troubled assets that were dragging down those banks. These assets include residential and commercial mortgage loans, mortgage securities, corporate leveraged loans and credit-derivative positions.

“As the US central bank, the Fed has a mission to maintain financial and economic stability and contain systemic risk in the markets. It lends only when the loans can be secured to its satisfaction, according to laws that govern the Feds activities.”

There is a key novelty in the monetary set up that has condoned both the banks and the Fed slipping down that treacherous slope. In 1970, largely because of Washingtons entanglement in the Vietnam War, it abandoned the gold standard. This analysis is in no way a defence of or nostalgia for the gold standard. It was rarely what it was reputed to be even in a far less tumultuous world. There was rarely enough gold to go around. But it created the illusion that money and sovereign credit was something you could test with you knuckles. Today everything is debt and with the drop in the standard of economics courses in our universities, the difference between the debt of a great sovereign land with its taxing powers on every domestic product or even asset in the land, and the debt of a wildly extended corporation or bank is so beyond comparing that it becomes antithetical, And by saddling the central bank with the debt that has twisted and crippled private banks in their growth mania, unless we grasp and protect that distinction, we are lost in the woods.

Returning to the WSJ: “The Feds lending could well swell by another $1 trillion or more in 2009 as its liquidity programs are tapped further by borrowers and it purchases more bonds, such as those issued by Fannie Mae and Freddie Mac, as well as by student loans auto loans credit-card receivables and small-business loans.

“The result would be a Federal Reserve balance sheet several times its size 18 months ago, when most of the Feds assets were Treasury securities.

“While the Fed has never had a loss before, notes James Bianco, a president of Bianco Research in Chicago, its record may not mean much today. Its a whole new ballgame for them. Weve never seen anything like this in terms of the Fed broadening its reach before.

“The Feds program to lend up to $200 billion to purchase securities backed by consumer and small-business loans will be protected by a $20 billion contribution from the Treasury. That means losses from the securities would have to exceed $20 billion before the Feds loan is impaired.

“The Fed would be exposed to losses on the assets of Citigroup and Bank of America only after the banks themselves and other government entities have absorbed tens of billions in losses. But if that happens, the central banks exposure to risk could balloon. The Fed has committed to Citigroup and about $90 billion to Bank of America, though it is unlikely that much will be needed.

“Maiden Lane II LLC and Maiden Lane III LLC, created late last year to hold illiquid subprime-residential mortgage-backed securities previously owned by AIG, as well as collateralized debt obligations in insured, have so far not reported substantial write-downs that would impair the loans of roughly $43 billion the Fed has provided to the two companies.

“Those securities were worth about half their original values at the time they were purchased by the two firms, and AIG agreed to absorb initial losses up to $6 billion. Their performance is largely tied to that of subprime borrowers.”