Thursday, March 20, 2008

The Fed becomes a Subprime Lender

The Federal Reserve may be a central bank with special rights and obligations, but in the end it, too, is a bank and has to be very careful who it lends to and what kind of collateral it accepts in exchange.

From a bank analyst perspective, during the last few months the Fed has become increasingly more lax in its lending practices. It is financing highly leveraged investment banks and brokers and accepting a wide range of illiquid securities as collateral, particularly MBSs.

As of March 12, 2008 the Fed had almost $891 billion in assets, of which $660 billion were in Treasury bills and notes and $170 billion in an assortment of repos, the TAF facility, etc. The most recently announced programs like the TSLF ($200 billion), the open-ended discount window facility for investment banks/brokers and the $30 billion loan to Morgan (i.e. Bear's toxic assets) are not shown yet.

Like any other bank, the Fed does not have an unlimited amount of money to lend - all it has is about $660 billion in Treasuries that it can exchange for other, less marketable securities (and it has already announced programs for a big part of that). In contrast, US home mortgages alone amount to $10.5 trillion; if things keep unraveling, the Fed's balance sheet will prove very small for the role it has now chosen for itself.

As for the liability side, the Fed has issued about $781 billion of its own Federal Reserve Notes, i.e. dollars. Our currency is thus increasingly going to be backed by lower quality, riskier assets that no one else wishes to buy or lend against, instead of Treasurys. In effect, Mr. Bernanke is betting the farm on a quick real estate/mortgage turnaround and a very shallow recession. Worse still, instead of charging a higher interest rate for the loans made against the riskier collateral, the Fed keeps cutting rates.

Let's summarize: riskier borrowers, low quality collateral concentrated on real estate, questionable appraisals for market prices and "low, low rates". Is the Fed turning itself into a sub-prime lender? If I were a bank examiner, I would want to have a quiet word with Mr. Chairman about his lending practices.

And if I were a shareholder or creditor of the Federal Reserve Bank (remember what its liabilities are), I would be worried. As, indeed, so many already are - they are those who are exchanging their dollars for other currencies and commodities.