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Friday, April 11, 2008 10:58 AM

Fed Is Not King Midas

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Before we get to King Midas, let's recap the Fed's previous attempts to turn trash into gold via lending facilities.

  • In the Term Auction Facility TAF, the Fed (via auction) swaps cash for questionable securities. This facility is for banks.
  • In the Term Securities Lending Facility TSLF, the Fed swaps treasuries for questionable securities. This facility is for banks.
  • In the Primary Dealer Credit Facility PDCF, the Fed swaps treasuries for questionable securities. This facility is for broker dealers.
In Failures of the Term Auction Facility, I showed how and why the facilities were failing to accomplish their mission. Simply put, banks do not trust each other, so they are unwilling to lend to each other except at an unusually wide premium. Instead of encouraging more bank to bank lending, the Fed has simply become a dumping ground for all the garbage mortgage backed securities no one wants to hold.

Dumping Ground Creativity

Yesterday in the Fed's Swap-O-Rama Gets Crazier I noted that banks and broker dealers are bundling up high-yield, high-risk corporate loans for which there is no market into Collateralized Loan Obligations (CLOs) for the express purpose of swapping with the Fed.

This is just the kind of thing that leads to more abuse and more mistrust, and the Fed's balance sheet is rapidly filling up with garbage. This sad situation was discussed in The Fed Is Terrified.

The Insanity Of Reverse Swaps

Now some would be geniuses are touting the Benefits of the Fed Doing Reverse MBS Swaps.
As reported by The Wall Street Journal, one of the more remote contingencies the Federal Reserve has considered is a mirror image of the Term Securities Lending Facility: it would take the mortgage backed securities pledged to it by dealers in return for Treasurys; then repledge them to other dealers, taking Treasurys back. Since the Fed is highly unlikely to fail, dealers might be more comfortable accepting MBS as collateral from the Fed than from other parties. But this might be complicated to do if the MBS are held by a custodial bank as is typical in a triparty repo.

Lou Crandall of Wrightson Associates thinks it’s cool idea.
This is not cool, it's absurd. It's scary that anyone could think this could possibly work. Let's chart this out mathematically.

Case #1
Citigroup swaps garbage with the Fed for treasuries.
The Fed swaps the same garbage with Citigroup for its treasuries back.
This is supposed to accomplish something?

Case #2
Citigroup swaps garbage with the Fed for treasuries.
Lehman swaps garbage with the Fed for treasuries.
The Fed swaps Lehman's garbage with Citigroup to get treasuries back.
The Fed swaps Citigroup's garbage with Lehman to get treasuries back.
Lehman holds Citigroup's garbage.
Citigroup holds Lehman's garbage.
This is supposed to accomplish something?

Lou Crandall Writes: The reverse swap is intriguing because it is sufficiently exotic that it might sidestep some of the traditional legal issues. My hat is off to whoever thought of it. That is one option that hadn’t occurred to me. The Fed could provide guarantees in the financing market that would substantially expand its balance sheet resources through the equivalent of a matched-book operation. With sufficient leverage, they could revalidate a huge range of privately-financed mortgage debt.


More amazing still is because of triparty collateral agreements there are logistical hurdles to clear. Apparently everyone is assuming that the moment the Fed touches something that it is good as gold. That's one hell of an assumption.

Wouldn't it be much simpler to have the Fed guarantee the debt and forget all this swapping madness? No I do not want that to happen, I am just stating the insanity of all this swapping if the only purpose is to get the "Midas Touch" from the Fed.

Logically speaking, this proposal would have the Fed guarantee all bank and broker dealer debt simply by touching it. And this is not a "cool idea", it's insanity. The Fed is not King Midas.

Mike "Mish" Shedlock
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