This is the best explanation I have seen as to why the Fed set up the TSLF, and allowed it to accept less than stellar paper:
"The real problem began in late February, as several of Wall Street's biggest investment banks prepared to close their books for the quarter and realized they were looking not only at big declines in profit from issuance of new stocks and bonds and fees from mergers and acquisitions, but also another round of write-offs in the value of their holdings. In response, the banks began to hunker down, instructing their trading desks to raise margin requirements for hedge funds and other customers, requiring them, in effect, to post more collateral on their heavy borrowings.
Thus began a chain reaction in which hedge funds began selling what they could -- largely mortgage-backed securities guaranteed by Fannie Mae (FNM), Freddie Mac (FRE) and Ginnie Mae -- to raise the cash to meet their new margin calls. That wave of forced selling drove down the price of those bonds, which prompted more margin calls and more forced selling. By the end of last week, the interest rate spread on those securities -- the difference between their yield and that of risk-free U.S. Treasury bonds -- had jumped four, five, even 10 times the normal rate.
Among those caught up in the vicious cycle were hedge funds run by such blue-chip names as KKR and Carlyle Group, along with Thornburg Mortgage, a big mortgage lender. News of their troubles swept through Wall Street, heightening the sense of panic, as did rumors that Goldman Sachs (NYSE:GS) was about to post big losses and Bear Stearns (NYSE:BSC) was about to run out of cash. Meanwhile, Lehman Brothers (LEH) announced that it would lay off 5 percent of its staff in what was viewed by many as a first installment of a consolidation that would eventually eliminate 20 percent of the jobs on Wall Street. Analysts began to warn that financial-sector losses from mortgages, commercial real estate, failed takeover loans and other bad gets could reach as high as $1 trillion.
It was against this backdrop that the Fed announced Friday that it would auction $200 billion in additional loans to banks looking for cash to lend or use as reserve capital. By accepting AAA-rated mortgage-backed securities as collateral for the loans, the Fed aimed to restore confidence and trading in that beleaguered market and begin to put a floor under prices."
Read the entire article -- but that explanatory is the gravamen of the Fed's actions...
A Bailout For Everyone
Wednesday, March 12, 2008; Page D01