After Lehman Brothers failed, the Fed pulled out the stops – and took in some junk.
Documents released Wednesday by the Federal Reserve detail how the central bank extended trillions of dollars in credit to global banks during the crisis of 2008-2009 to keep the system afloat.
Initially the loans were secured by investment-grade bonds and other high-grade collateral. But after the failure of Lehman threatened the global financial system, the Fed changed the rules to accept junk-rated debt as well.
There’s no sleight of hand going on here. The Fed publicly announced the changes in September of 2008, saying it made them to create a substitute for the triparty repo financing system that collapsed during the crisis.
But by taking lower-rated bonds, the Fed exposed itself to a greater risk of losses. Those losses didn’t ensue, but a default by a borrower using low-rated collateral could have hit the central bank’s reputation, which by now has been under attack more or less continuously for three years.
“We took an enormous amount of risk with the people’s money,” Dallas Fed President Dick Fisher (right) said Wednesday. But “we didn’t lose a dime and in fact we made money on every one of them.”
Among the main channels the Fed used to support the system was the Primary Dealer Credit Facility, which the central bank created in the spring of 2008 following the implosion of Bear Stearns. The PDCF gave nonbank broker-dealers access to emergency Fed funding in parallel with the discount window used by Fed-supervised commercial banks.
Loans made under the PDCF were secured by collateral and discounted to protect the Fed from risk of loss should it have had to sell collateral in the event of a default. Initially the Fed accepted only investment-grade collateral, but that rule went out the window with the failure of Lehman on Sept. 15, 2008, and the Fed then expanded the eligibility rules to qualify so-called junk-rated bonds.
A look at the data published Wednesday by the Fed shows that the 10 PDCF loans secured by the lowest-rated bonds – those ranked triple-C or lower by S&P – included $21 billion of such low-grade collateral.
While the rating agencies have not exactly distinguished themselves during this crisis, even critics acknowledge that taking bonds with low ratings carries some not inconsiderable risk.
“I don’t pay much attention to the rating agencies,” said Ken Hackel, an investor and author of a cash flow analysis book. “But the correlation between ratings and defaults is strong.”
There were $111 billion of loans in the group, made to three borrowers: Citigroup (C) (five times), Bank of America (BAC) (four times) and Morgan Stanley (MS) (once). The loans were secured by $119 billion of collateral – meaning the triple-C-rated bonds comprised 18% of the assets backing the loans.
The banks applauded the Fed for standing behind them.
“The programs offered were meant to provide liquidity backstops as well as instill confidence in the market,” Citi said. “They achieved these goals. Citi’s usage of these programs was appropriate at the time.”
“As we have previously disclosed, Morgan Stanley utilized some of the Federal Reserve’s emergency lending facilities during a time of immense financial turmoil throughout the banking sector and the broader market,” Morgan Stanley said. “Its actions were timely and critical, and we commend the Fed for providing liquidity and stabilizing the financial system during that period.”
And Bank of America? It couldn’t say enough for the Fed.
The funding and guarantee programs were an example of a successful government initiative at no taxpayer expense. The programs enabled the U.S. financial system to continue to operate, preventing a recession from becoming much more severe. Bank of America and its peers participated in these programs to various degrees and paid the government for the borrowings and guarantees. The programs helped our customers such as borrowers, auto dealers, depositors and money market fund investors continue to do business as usual despite virtually unprecedented disruptions in the financial markets. We have repaid, with interest, all of the our debt securities issued with the government guaranty as they have matured with the exception of those debt securities whose terms have not matured. All such debt securities mature no later than June 2012, and we fully expect to pay those debt securities as they become due.
Who says the bankers aren’t grateful for their taxpayer support?