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.

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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.”

CONTINUED: Is the Fed contradicting itself?

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