The Fed has opened up fresh credit to struggling banks and financial firms by accepting close-to-worthless CDOs as collateral. The practice is allowing banks to raise oceans of capital. The Fed says $32.6 billion was leant through the discount window last week, with CDOs being used as collateral.
So what’s the problem? There’s no stand-alone market for this kind of debt anymore. Banks are issuing new CDOs solely to use them as collateral to borrow through the discount window. This is what got us into trouble in the first place. Bloomberg:
One year ago, Treasury securities accounted for 92 per cent of the Fed’s assets. Now it’s down to 65 per cent.Both the idea of accepting collateralized debt obligations and the timing of such an action strike many observers as bizarre.
“We just went through a period of bundling lousy mortgage loans into pools and on the theory that few would fail, and labelled the package AAA,” said blogger Mish Shedlock, an investment adviser at Sitka Pacific Capital Management, in a post on the latest Fed Swap-O-Rama. “That experiment didn’t go so well.
“Now we see CLOs being created for the express purpose of swapping to the Fed,” he wrote. “There is no market for the underlying loans. Yet Moody’s, Fitch and S&P are supposed to rate this garbage investment grade so it can be swapped with the Fed.”
Some argue that this time around, CDOs won’t tank, simply because the Fed underwrites them. Sounds like other bromides that are true until they aren’t–such as “too big to fail.”
Assessments of the degree of credit risk the Fed is assuming by outsourcing its balance sheet run the gamut from a lot to a little to not much. The not-much argument didn’t register until I talked to Neal Soss, chief economist at Credit Suisse.
“If you look on a dollar bill, you will see two important phrases,” Soss said. “One is ‘Federal Reserve Note.’ If this is the Fed’s liability, maybe I should care about the asset,” he said.
“The other is: ‘This is legal tender for all debts, public and private.’ The police power of the state says, this will be money.”
It’s money because the government says it’s money and the public has confidence it is.
Which doesn’t mean that the value of that “money” won’t keep plummeting like a lead balloon.
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