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What a Deal: Trash for Treasuries

Saving the nation’s financial system from reckless banks and brokerage firms is an enormous job, heaven knows. But somebody’s got to do it, so the Federal Reserve Board, with its taxpayer-funded balance sheet, stepped in.

To grease the gears of the nation’s seized-up credit markets, the New York Fed in recent months created three new lending entities. Together, they allow banks and financial firms to swap up to $350 billion of securities they cannot sell for cash or United States Treasuries.

The entities will stay in business as long as the markets for mortgage securities and other orphaned “investments” are closed, the Fed said. This allows institutions to exchange their trash for cash that they can turn around and lend to corporations or individuals.

The nature of these new Fed lending facilities is not without risks, of course. One of those risks is that taxpayers may have to cover losses if a firm or bank fails to repay a loan.

So far, the Fed’s noble experiment seems to be working. Back in March, when two of the entities were set up, banks and brokerage firms fairly beat down the Fed’s door to swap unwanted securities for cash or Treasuries. In early April, for instance, the Fed had to turn away many of the nation’s largest brokerage firms when they showed up, trash bags a-bulging, at the lending entity created just for them. These firms hoped to unload securities valued at almost twice what the Fed was offering to lend.

Things are a bit calmer now. Last Thursday, the Fed said the brokerage firms applying to the entity put up securities valued at only $7.24 billion, less than one-third the amount the Fed was willing to exchange for Treasury securities.

To be sure, the Fed is fairly well protected against the possibility that a commercial bank will renege on the loans. These institutions provide excess collateral — typically 100 percent of their borrowings — when they tap the entity, and the Fed can go after their other assets if need be.

But deals with brokerage firms are another story entirely. And the particulars of those transactions worry Josh Rosner, an analyst and expert on mortgage securities at Graham-Fisher, an independent financial research company in New York.

For starters, brokerage firms swapping securities at their new Fed window — the Term Securities Lending Facility — do not supply the excess collateral that commercial banks do. And look at the securities the Fed accepts in these swaps: residential and commercial mortgages and other asset-backed issues.

Sure, the Fed requires that the securities must be rated triple-A to qualify for a Treasury swap. But as we’ve learned over the last year and a half, such ratings are unreliable.

SOME Fed officials agree. Last month, Donald L. Kohn, vice chairman of the Federal Reserve, addressed bankers at a credit market symposium in North Carolina. “I think part of the work-list for the regulators is to re-examine the extent to which we ourselves are relying on these rating agencies to gauge the risks that you guys are taking,” he said. “I think there was far, far too much reliance on credit ratings all round.”

Is the Fed contradicting itself?

And in a speech on April 10, Ben S. Bernanke, the Fed chairman, said: “Investors must take responsibility for developing independent views of the risks of these instruments and not rely solely on credit ratings.”

Yet the Fed is doing precisely that when it accepts triple-A rated mortgage securities. “This is classic ‘do as I say, not as I do,’ ” Mr. Rosner said.

More worrisome, he added, is the fact that the Fed doesn’t examine the basis for bestowing a triple-A rating on these securities. Are they triple-A based on the soundness of the issuer? Or because of an insurance policy guaranteed by M.B.I.A. or the Ambac Financial Group, the troubled financial guarantors?

Both M.B.I.A. and Ambac currently carry triple-A pedigrees from Moody’s and Standard & Poor’s. Fitch, the other major rating agency, cut them both to double-A earlier this year. But as long as the guarantors carry triple-A’s, the securities they guarantee carry them as well.

But what if the guarantors themselves are downgraded? That brings us back to the Fed’s lending entity. If securities posted by brokerage firms at the Fed lose their triple-A rating, they will no longer be accepted as collateral. The brokerage firm would either have to come up with other acceptable collateral or repay that part of the loan immediately.

And if the firm could do neither? The Fed could go after the firm’s other assets. Or taxpayers could get stuck with the bill.

Such a possibility may be farfetched — let us hope it is. But stranger things have happened recently — Bear Stearns disappeared overnight, remember? And a downgrade of the financial guarantors would result in major market upheaval as enormous amounts of securities formerly considered triple-A would have to be downgraded, too.

How much of the collateral posted at the Fed by brokerage firms is triple-A solely because of financial guarantors’ insurance, which is known as a wrap? The Fed won’t say.

But Mr. Rosner said it only stands to reason that much of the mortgage and asset-backed collateral posted at the Fed falls into that category. “Investment banks who are posting the collateral know if the securities are natural triple-A or only triple-A because of the wrap,” he said. “Obviously the incentive would be for them to post triple-A collateral of lower quality to the Fed.”

LAST week, Moody’s said that worsening losses on second lien residential mortgage securities might have an impact on its triple-A ratings on M.B.I.A. and Ambac, known as the monoline insurers. The insurers have significant exposure to these mortgage securities, Moody’s said. Also, incurred losses within both firms’ portfolios are meaningfully higher now, elevating the rating agency’s concerns about capital levels relative to the guarantors’ triple-A ratings.

Both companies disputed Moody’s view that they may need to raise capital to keep their triple-A ratings.

Clearly, it is in the Fed’s interest to make sure that M.B.I.A. and Ambac are well capitalized and deserving of triple-A ratings. In a speech last Thursday, Mr. Bernanke urged banks to keep raising capital to shore up their loss-ravaged balance sheets. He should add the financial guarantors to his list.

Henry M. Paulson Jr., the Treasury secretary, said last week that the credit crisis was abating. If he truly believes this, then the Fed should tighten its lending entities’ collateral requirements and stop being what Joan McCullough, a macro strategist at East Shore Partners in Hauppauge, N.Y., called “a monetary bordello.”

To be sure, crisis times call for creative measures. But as long as Wall Street is allowed to swap trash for Treasuries on the taxpayers’ dime, don’t try to tell me this horror show is over.

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