Junk-Grade Fed?

Here’s an interesting editorial today from the New York Sun:

What caught our eye in the markets last week was the verdict by Grant’s Interest Rate Observer that, by its lights, the Federal Reserve Bank of New York was no longer a “presumptive triple-A” credit but rather one of “mid-grade junk” quality. This news didn’t exactly rock the financial world, as Grant’s is no kind of formal rating agency, even it if does have as elite and savvy a readership as any market newsletter could want. It wouldn’t surprise us, though, were people — including some in Congress — soon to sit up and take notice of a worrying set of facts.
Grant’s was reacting to the sudden appearance on the Federal Reserve’s balance sheet of $60 billion in lending under the new Term Auction Facility. The New York Fed’s share of that $60 billion is no less than $44.9 billion. The TAF is a credit facility. Its purpose is to lend to banks under stress in the sub-prime credit crisis. The banks front collateral against which the Fed advances money. “The rub,” Grant’s writes, “is the quality of the collateral.” It quotes a Financial Times interview with one financial strategist, Christopher Wood, as saying that banks “are increasingly giving the Fed the garbage collateral nobody else wants.”
The New York Fed doesn’t seem overly concerned about all this. When our Julie Satow called over to the fortress on Liberty Sreet a spokesman said the bank took the downgrading by Grant’s to be a form of humor. “Reserve banks operate under well-established guidelines regarding margining and collateral,” the spokesman said. However that may be, the Fed’s Web site invites would-be borrowers to submit collateral of decidedly low quality. Against this dubious stuff, the Fed stands ready to lend on highly generous terms — as much as 90 cents on the dollar against “private label” mortgage-backed securities. Unless we have been misreading the papers these past six months, the Fed is alone in assigning that much value to that particular class of mortgage asset.
It’s a little-noted irony that the Federal Reserve, the supposed conscience of the American banking system, is itself an exceedingly highly leveraged institution. At the latest weekly tallying up, $881 billion in assets rested on just $38.5 billion in capital, As for the New York branch office, $312 billion in assets (including those $44.9 billion in TAF credits) were balanced on a little less than $10 billion in capital. The scant showing of capital was of no especial concern when the Fed owned nothing but Treasury securities. But now that it’s in the business of lending against what may well be mongrel mortgages, that extreme leverage introduces real risks. As Grant’s points out, it’s not so farfetched to imagine the Fed itself needing a bailout one of these days. We wonder how a headline on the order of “Fed insolvency fears” would play in the already skittish world currency markets.
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Why not let an independent auditor check up on the value of the collateral that the Fed is so willingly taking aboard? It would not be lost on such an auditor that the New York Fed is, as they say on Wall Street, a kind of “hidden asset story.” It carries slightly more than $4 billion of gold on its balance sheet at the early 1970s price of $42.22 an ounce. At today’s prices, that works out to more than $90 billion. On that basis, as the editor of Grants, James Grant, sketched it for us, “the hometown central bank would be in the clover, credit-wise.” He goes on to say that “the Fed is unlikely to acknowledge the great bull market in gold bullion for the obvious reason that it, itself, is largely the author of it.” Or, to put it another way, if the salvation of the Fed is all the gold it has in its basement, what does that tell us about the monetary system on which the rest of the world is relying?

Posted by on February 25th, 2008 at 10:06 am


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