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Thursday, April 10, 2008 3:46 PM


Fed's Swap-O-Rama Gets Crazier


The Federal Reserve's Term Auction Facility, TAF, has failed to produce the intended results - encourage more bank to bank lending at reduced rates. That should not be too surprising. If the Fed is willing to be a "swapper of last resort," why should banks risk lending to each other?

After all, bank-to-bank loans are unsecured. Who wants that risk, especially when banks have every reason not to trust each other? Please see Failures of the Term Auction Facility for detailed analysis of this situation.

CLOs Pawned Off To The FED

Now things are getting even crazier at the Fed's Swap-O-Rama as Buyout CLOs Are Being Used for Fed Loans.

Wall Street firms may be bundling high-yield, high-risk corporate loans into securities to use as collateral to borrow from the U.S. government, according to a report by Morgan Stanley analysts. Securities firms can borrow against collateralized loan obligations at the Federal Reserve's Primary Dealer Credit Facility, the analysts said. The Fed set up the facility last month, its first extension of credit to non-banks since the Great Depression.

Lehman Brothers Holdings Inc., the fourth-largest U.S. securities firm, last month created the $2.8 billion Freedom CLO, the largest this year, out of loans that couldn't be readily sold to investors, such as for buyouts of payment processor First Data Corp. and power producer TXU Corp. JPMorgan Chase & Co., Deutsche Bank AG and Barclays Plc also underwrote CLOs in March, according to data compiled by Bloomberg.

They're also "an easy way for banks to reduce balance sheet risk, which indirectly helps reduce capital requirements, by funding the AAA through the Fed and selling the equity, which provides high yield to investors," said Peter Plaut, an analyst at hedge fund Sanno Point Capital Management in New York.
What passes as "analysis" these days is rather shocking. We just went through a period of bundling lousy mortgage loans into pools and on the theory that few would fail, and labeled the package AAA. That experiment didn't go so well.

The poster child for this is an 92.6% AAA rated Washington Mutual(WM) mortgage pool affectionately known as WMALT 2007-0C1. Here is the status of that pool as of March 31, 2008.

March Pool Stats
  • 25.3% 60 day delinquent or worse
  • 13.35% Foreclosure
  • 4.44% REO
Bear in mind, that pool is less than a year old. For more details, please see WaMu Alt-A Pool Deteriorates Further.

Now we see CLOs being created for the express purpose of swapping to the Fed. The reason the CLOs are being created is there is no market for the underlying loans. Yet supposedly Moody's, Fitch, and the S&P are supposed to rate this garbage investment grade so that it can be swapped with the Fed. Amazing.

This idea is endorsed by Plaut who writes: It's "an easy way for banks to reduce balance sheet risk, which indirectly helps reduce capital requirements, by funding the AAA through the Fed and selling the equity, which provides high yield to investors".

Sadly, this is just the beginning of crazy ideas. I guarantee it. More are coming, and they will all gather proponents. Yet every one of them will further undermine trust. I guarantee that too.

Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com
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