Bar Continues to Drop Dangerously on What the U.S. Will Accept as Collateral

In a Bloomberg article yesterday, Federal Reserve Vice Chairman Donald Kohn said that the central bank’s emergency lending programs aren’t creating a significant risk for U.S. taxpayers and went on to clarify that the major sense of security is prompted by the quality of the collateral pledged against these loans. To quote Kohn:

We are not taking significant credit risk that might end up being absorbed by the taxpayer. For almost all the loans made by the Federal Reserve, we look first to sound borrowers for repayment and then to underlying collateral.

Citi (C) is a sound borrower? Met Life (MET) is a sound borrower? Probably yes... if the soundness is determined by the joke that are the "stress" tests: everyone is all too well aware that all 19 stress testees will pass. How long they will survive after they "pass", especially once unemployment hits a possible high of 20% (if corporate spreads are any indication) relative to the government's downside case in the 8-9% range, only time will tell (click on chart to enlarge).

(chart hat tip Richard)

The more relevant question is what is the true quality of the collateral that the Fed is willing to accept in exchange for providing taxpayer cash as loans to assorted institutions of all shapes and sizes. The data below demonstrates that as the credit crisis has progressed, the Fed has become willing to accept more and more risky collateral, with some of the most recent incarnations of the program essentially accepting any assets, including the toxic variety. As Zero Hedge has disclosed previously, the chart below (click to enlarge) demonstrates the various bailout programs (and key bailout players) sorted chronologically.

The dangerous thing here is that as time has evolved and the crisis has deepened, the Fed has become willing to accept much less sound assets as collateral, initially the default being safe US Treasuries (although with US Debt/GDP likely to skyrocket past 100% over the next several years, even this category can be perceived as risky), however the bar has subsequently dropped lower and lower to include first tier commercial paper, investment grade debt, and at the bottom of the rung: a full range of discount window collateral which includes, among others, residential and commercial real estate loans, CMOs, and corporate bonds.

Does this telegraph that the Fed, in loosening its high quality collateral standards, is anticipating expanding the bailout programs to a point where it is willing to accept not only HY bonds as collateral but outright equities?

The last preposition is frightening, especially if there is any direct or indirect method that the Fed or the Treasury possess in order to manipulate equity price levels, as this would effectively translate into the biggest conflict of interest in history. But even assuming that conspiracy theories are too far-fetched for the purpose of this rational discourse, the declining collateral quality trend is very troubling. If eventually the system reaches a point where taxpayer money is collateralized by the investments (speculations) that these very same taxpayers (for the most part) invest in equities and other market securities, the circular logic of bidding up assets in order to prevent collateral quality from falling (and thus wiping out taxpayers) will become the de facto norm. In a way, this puts yet another twist in the ongoing bifurcation between U.S. taxpayers and U.S. investors who very often are the very same individuals.

The conclusion is that if one did not fear the "full faith" retaliation of the U.S. government, one would be tempted to define Kohn's statement as not only groundless cheerleading, but ultimately predatory disinformation dissemination. However, as we here at Zero Hedge observe our daily fear of the abovementioned phenomena, we would not go so far as to make that broad an assumption. Instead we will leave this topic as an open question, welcoming reader feedback, and hope to have provided sufficient food for thought as the U.S. economy deteriorates more and more from the consequences of the biggest credit unwind in the past 70 years.

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Comments

[PROXIMO:]

Kohn's statement is typical of the lies from the federal government. I'd sooner believe graffiti written on the walls of a men's room in a pool hall. The government has managed to create a situation, through corruption and incompetence, where the average citizen is screwed at every turn. Hard to imagine any outcome now that doesn't involve much more pain for the taxpayer. Compliments of the on-the-take elected and appointed jerks.

Apr 19 01:25 AM

[Simon Smelt:]

Greta article. Interesting that you - b y implication - take it as given that the Federal Reserve is a branch of government acting pretty much seemlessly with Treasury. I agree but a year ago that would have been a shocking proposition - undermining the "independent role" etc. In short, long-standing safeguards are vanishing rapidly.

Apr 19 02:01 AM

[Fighting Yoda:]

Fed is in completely unchartered territory - printing money - lender of only resort and buyer of only resort. All Fed governors have taken up the role of cheer leaders, the role earlier meant for politicians. Greenspan politicized the office; Ben has taken it to the next level.

One way or other this will end very badly, the bearded fool should simply go back to the Princeton debating society.

Apr 19 04:52 AM

[CautiousInv...:]

Great article.

There are several implications to this disturbing trend and one is that the Fed........in the face of rising inflation expectations........will be limited in how quickly it unwinds its position.

Up to this point, Bernanke and others have assured us that upon the first signs of inflation they will be able to contract the Fed balance sheet in a timely and orderly manner. Of course this ignores political pressure to maintain employment, questionable holdings noted by the author and longer dated purchase/loan agreements.

The Fed is quickly losing flexibility

Apr 19 07:48 AM

[morph366:]

Well said.

Unfortunately your comment about "the circular logic of bidding up assets in order to prevent collateral quality from falling (and thus wiping out taxpayers) will become the de facto norm" is precisely the vicious spiral that will eventually cause the rescue plans to come undone.

Apr 19 08:43 AM

[Roger Knights:]

"as the credit crisis has progressed, the Fed has become willing to accept more and more risky collateral, ..."

Royals are rare in a house of cards.

Apr 19 09:00 AM

[Bill S. Friend:]

Bernake stated from the onset that any and all means available to the fed will be used, and specifically mentioned equities. This is evidenced in the fact that bad news carries no inertia in the current markets, clearly forces are at work that have an agenda disconnected from conventional market wisdom.
Stress tests and public offerings will be positively affected by an increased share price, even if only temporarily. There is very little choice involved, as the Dollar is a fiat currency and this has devolved into a confidence game. The idea that if the true health of our financial institutions was known, it would destroy confidence in the USD. This has been the signal for quite some time now, and the acceptance of more and more questionable collateral indicates a growing desperation.

Apr 19 09:21 AM

[Lilguy:]

My suggestion: The taxpayers of the US (no, NOT the USG, but the people whose money is financing all this) should hire a firm to audit the books of the Federal Reserve in excruciating depth. The results--in equal depth--would be published for all the world to see accompanied by the usual accounting statement of whether the Fed is a "going concern."

Even I might enjoy reading that report.

Apr 19 10:49 AM

[User 353732:]

The Government ( the Fed with the enthusiastic support of the Treasury and WH and no objection from Congress) has concluded. it would seem, that the solution to all the evil caused by massive private , irresponsible,sub-prime lending is grangantuan public, irresponsible, sub-prime lending; the remedy for large private deceit is larger public deceit.
If the consequence of private excess and corruption is a deep economic compression and high unemployment, then what will be the consequence public excess and corruption?
The idea of using one poison as antidote to another is an old one but it is understood that it is not the SAME poison.

Apr 19 11:53 AM

[dcb:]

fed has never been audited and does not allow it.


On Apr 19 10:49 AM Lilguy wrote:

> My suggestion: The taxpayers of the US (no, NOT the USG, but the
> people whose money is financing all this) should hire a firm to audit
> the books of the Federal Reserve in excruciating depth. The results--in
> equal depth--would be published for all the world to see accompanied
> by the usual accounting statement of whether the Fed is a "going
> concern."
>
> Even I might enjoy reading that report.

Apr 19 12:37 PM

[dcb:]

I think it's funny we all go to work each day without a banking system and nobody notices. The price will be paid, some time. where, and when I do not know.

Apr 19 12:40 PM

[fleeing omega:]

Another great article from Tyler and a very salient comment by Morph which I think artfully summarizes the motives underlying the rather alarming policy decisions, now spanning 2 administrations.
Although you won't hear it form the guys in charge, the risks are equally clear, i.e., that this desperate propping up of illegitimate asset values may well ultimately fail, and in that case we find ourselves at the bottom of a big hole in the financial system, but now with a mountain of additional, futile debt pile piled on top of us. This is a disturbing possibility that I just can't shake off, regardless of the "cool aid" being handed out. I understand the logic behind the stimulus approach, but that facile approach has already been tapped repeated for multiple businesss cycles. The present situation looks a lot like an ill-advised gamble that that this mother of all stimuli will "work", using the taxpayers as collateral.

Anyway, the statement by Kohn was, for me, shocking in its brazen absurdity, even from the standpoint of one not trained in economic theory. If everything is really going so great, why are they resorting to all these ever more extreme tactics? It should at least make one wonder...

Apr 19 01:58 PM

[fleeing omega:]

By "stimulus" I am also including the bail outs. It is the combined TOTAL debt that is particularly worrying, although each component is grim in its own right. But I apologize for the imprecise use of terms.

Apr 19 02:23 PM

[Ergo:]

Good article, and excellent discussion by all. It seems that a lot of us see the train wreck coming. But what perplexes me is figuring out when. For a lot of people facing unemployment, the disaster is happening now. For the rest of us, it's hard to say what happens next. But having an increased risk factor at work makes playing stocks a heck of a lot more dangerous.

Apr 19 02:40 PM

[Carlos Lam:]

Tyler, excellent article yet again!

I'm particularly interested in the unemployment forecasts predicted by bond spreads. I just don't understand how or why bonds would be more predictive of economic trends than equities. An equity investor is predicting that a company's product/service will generate income and that its management will be able to marshal resources to minimize costs and produce growth. A bond investor is basically predicting that a company will not become insolvent.

It seems to me that the equity investor will have had to "dig deeper" into the company than the bond investor and, therefore, should know more about the company. Yet, time and again, the bond market seems almost prescient. Can anyone explain this?

Apr 19 11:21 PM

[nmelendez:]

Why is everyone so upset at the Fed. You saw the train coming down the tracks. Why did you not get outta it's way? I did. The Fed did not use houses as flips, playing a ponzi scheme. You know you would get burnt if you ended at the end of the scheme. Why did you borrow twice your annual salary just to keep up with the joneses on your credit card? Did you think markets go perpetually up or down?
I am a Bill Gates fan. His first rule is ... "Life's not fair, GET OVER IT".
Here's a hint...Follow the Dow/Gold relationship. You won't lose.

Apr 19 11:44 PM

[juicyjoo:]

Don't be too suprised if they using taxpayer funds to prop up the stock market. The world's 2nd largest economy is already doing so (Japan). Article can be found at bloomberg.com.

Apr 20 12:10 AM

[Allan Frain:]

Unfortunately, this can go further. In the extreme we could have new Legal Tender laws assigning value to Toxic Assets. Only Congress can rein in Bernanke and Geithner. Only the Electorate can hold Congress accountable. In a democracy the people get the government they deserve. Apparently, we do not deserve a very good Government. That needs to change.

Apr 20 06:37 AM

[Osterix:]

To: Carlos,
This is not original. I think part of the explanation is that bond investors are basically pessimists and equity investors are basically optimists. The BI's start out looking for things that will go wrong. The EI's assume that things will go well. The result is that BI's wind up making a more realistic analysis of an economic situation than EI's. The BI makes a defensive investment. He just wants his capital back plus promised interest. The EI wants growth of his capital and is willing to give up the expectation of certainty in exchange for the hope of future gain of an unknown size that is large enough to justify the risk he is taking. Many studies have shown that humans consistently underestimate risk when making investments. This tends to confirm that EI's are not as realistic in their decision making.


On Apr 19 11:21 PM Carlos Lam wrote:

> Tyler, excellent article yet again!
>
> I'm particularly interested in the unemployment forecasts predicted
> by bond spreads. I just don't understand how or why bonds would be
> more predictive of economic trends than equities. An equity investor
> is predicting that a company's product/service will generate income
> and that its management will be able to marshal resources to minimize
> costs and produce growth. A bond investor is basically predicting
> that a company will not become insolvent.
>
> It seems to me that the equity investor will have had to "dig deeper"
> into the company than the bond investor and, therefore, should know
> more about the company. Yet, time and again, the bond market seems
> almost prescient. Can anyone explain this?

Apr 20 09:00 PM

[Freya:]

Reversion to the mean? The methods which got us to where we are will be employed to try to get us out.

Insurance companies have a problem. The assets they use as collateral have imploded. You wrote an article on Program trading. I suggest that the Traders are acting on behest of the Government to ramp Up the Stockmarket. At least until the "stress" test results are released.

Higher Stock prices: aids Insurers, aids replenishment of Pension Fund arrearages, aids Consumer 401ks, aids Financial Institutions, offsets deflationary aspects.

In its heyday, Program Trading occasionally comprised almost 50% of all trades on the NYSE( my memory, data currently deleted since the demise of the Major players created an apples to oranges comparison). But at 1/3rd up from around 23%, The Tail can still "wag the dog".

There are all sorts of new disclosure Rules, yet these trades are still released with a 2 week delay.

The Markets will do what they tell them to do.

Apr 19 12:21 PM