So the Federal Reserve is meeting tomorrow and Wednesday. They are likely to do nothing. The markets are likely to go nuts anyway.
Discuss.
Fed
The news that AIG had asked the Federal Reserve to provide a bridge loan worth tens of billions set teeth gnashing everywhere across the universe of market watchers. The now time worn phrase moral hazard was trotted out. Weren’t we supposed to be clawing our way out of this bailout business?
Our first reaction to the news that the insurance titan had gone hat in hand to the House of Bernanke was to ask: can they do that? We had fallen under the impression that the Federal Reserve lent money to banks, and more recently to investment banks. But we didn’t think the Fed was in the business of bailing out insurance companies.
It turns out we were wrong. The Fed is authorized by Depression era amendments to the Federal Reserve Act to lend to pretty much anyone, as David Zaring at the Conglomerate points out. So long as the circumstance are “unusual or exigent” the Federal Reserve may open the discount window to any individual, partnership, or corporation.
Lately we’ve been feeling that our own finances are a bit unusual and exigent but somehow we doubt that the Fed is going to allow us to borrow from the discount window. Maybe AIG will have better luck.
Who Can Access the Fed’s Discount Window? [Conglomerate]
We earlier reported that officials at the Federal Reserve and Treasury are scrambling to find a buyer for Lehman Brothers, perhaps going as far as bending or waiving rules that limit the ability of private equity firms to buy sizable stakes in investment banks. Part of the rationale for this may be because the Fed and Treasury want to avoid putting its own balance sheet or taxpayer funds into what would widely be perceived as another bailout.
There seems to be an increasing consensus among commentators that Lehman won’t be bailed out by the Federal Reserve or the Treasury. Over at RealTimeEconomics, Sudeep Reddy adds color to this idea by pointing out that to Fed officials it may well appear that they have already bailed out Lehman. The primary deal credit facility gives Lehman Brothers access to the discount window, allowing it to borrow cheaply against collateral arguably priced at inflated values. Indeed, Bill Gross of Pimco has publicly cited the facility as preventing him from withdrawing from trades with Lehman on the other side.
What’s more, the Treasury and the Fed may want to reduce the moral hazard issue in the market by allowing an institution to fail, Reddy says. But its not clear that they will have the luxury of adding discipline to the market. Lehman is deeply intertwined in the credit markets, particularly, and its failure could have unwanted ripple effects, rocking the stability of the broader financial markets. A better solution, some at the Fed believe, would be to find a willing buyer and arrange private financing without a Fed backstop. This most likely explains the Fed scramble to find a buyer.
Would the Fed Let Lehman Fail? [Wall Street Journal]
Late Thursday afternoon, long after the markets had closed and many on Wall Street had long since evacuated for the long weekend, the Federal Reserve revealed its estimates for the value the Bear Stearns assets it accepted as collateral for the $28.9 billion loan JP Morgan Chase used to buy the firm and prevent its bankruptcy. That collateral was worth just $28.8 billion, according to the Fed.
What this means is that the decline in the collateral value has already eaten through a good chunk of the $1.15 billion of exposure JP Morgan agreed to take as part of the deal. The collateral has already declined by 3.7% in a couple of months. Much of the collateral consists of mortgage linked securities, so unless that market turns around sharply, it seems likely that taxpayers will be forced to foot the bill for Bear Stearns collapse.
Indeed, The New York Post reported this morning that a hedge fund investor in JP Morgan is predicting further declines in the collateral values. Taxpayers are on the hook for any decline past the $1.5 billion hit JP Morgan agreed to take. The Fed is being criticized for not revealing more about the assets that make up the collateral. JP Morgan says it is bound by a confidentiality agreement not to comment.
Hedge Fund Report: Bear Buyout Could Cost Taxpayers [New York Post]
Corporate loan agreements are being drafted to include an express provision allowing lenders to transfer their loans to the Federal Reserve, a loan expert tells DealBreaker. The Fed has been accepting a much broader range of collateral in exchange for short-term loans through what is known as Fed “repos.” In a repo, dealers bid on borrowing money versus various types of general collateral.
The new provisions seem to anticipate the possibility that banks might use corporate loans in repos, accessing cash from the Fed in exchange for the credits. In the past the assignment provisions of loan agreements that governed transfers typically did not expressly permit transfer to the Fed. Instead, they permitted assignment to others commercial banks, insurance companies, investment or mutual funds or other entity that is an “accredited investor” under securities laws. The new provision illustrates the ever more pervasive role the Fed has in the current credit markets.
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Fed
Government Officials Worry About Bond Market’s Muted Reaction To Lehman News
By Bess LevinInvestors bid up Lehman Brothers’ bonds yesterday after news broke that the company was replacing two top executives. The price of protection on Lehman bonds also declined. This reaction–which starkly contrasts to the decline in Lehman’s share price yesterday–has government officials concerned.
Government officials who spoke to DealBreaker on the condition of anonymity said they are worried that the market is convinced the Federal Reserve won’t let a major US securities firm collapse. This is a cause for alarm because it indicates that investors are not taking into account full range of risks faced by investment banks, which could in turn remove an important market check on risky behavior. Although Lehman and its rivals have been pushing down debt levels recently, cheap debt that is unlinked to institutional risk could encourage a new round of re-levering, one official warned.
“What we saw yesterday was moral hazard in action,” the official said.
The price of credit default swaps for Lehman is now half of what it was in March, the Wall Street Journal pointed out this morning. That can be looked at as a dramatic demonstration of the value of having the Federal Reserve’s implicit guarantee of Lehman’s credit worthiness. In recent weeks, officials from the Federal Reserve have publicly remarked on the dangers created by this guarantee. On Wednesday, Treasury department undersecretary Robert Steel went out of his way to stress that the window was not a permanent guarantee for securities firms.
Just one day after Merrill Lynch chief John Thain urged that the Federal Reserve borrowing facility for securities firms be made permanent, a treasury official sounded the warning that this new investment banking borrowing window may be closed when it ends its initial run in September.
Under Secretary Robert Steel, whose bailiwick covers the domestic financial system, seemed to have crafted his remarks as a response to Thain’s. Yesterday Thain told attendees at a Wall Street Journal dealmakers conference in midtown Manhattan that he hoped the facility would be continued after its scheduled expiration. Speaking a the same conference today, Steel went out of his way to emphasize that the facility is temporary.
After he referred to the facility as the “temporary borrowing facility for primary broker-dealers,” Steel added: “Notice the first word in that phrase is temporary.”
When the moderator pointed out that Thain hadn’t used the word “temporary” when discussing the facility the day prior, Steel acknowledged that his remarks diverged from Thain’s.
“Notice I just used the word twice,” he said.
Steel left open the possibility that the window could remain open after expiration, adding that the regulatory framework for institutions permitted to borrow from the window remains unclear. The major commercial banks–including, most recently, Bank of America CEO Ken Lewis speaking to the conference this morning–have urged that investment banks be subject to the same regulations that restrict commercial banking. Yesterday Thain said he thought a less restrictive regulatory framework was more appropriate.
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Fed
Is Merrill’s John Thain Worried The Fed’s Investment Banking Window Will Be Closed In September?
By John CarneyAt a gathering of Wall Street dealmakers yesterday Merrill Lynch chief executive John Thain said he hopes the Federal Reserve will continue to permit securities firms to borrow from a new Fed facility launched amidst the implosion of Bear Stearns. We couldn’t help but notice, however, that Thain seemed a bit worried that the Fed isn’t going to keep the window open. To paraphrase a popular saying on Wall Street, “hoping” the Fed window stays open is not a strategy.
“I think it should stay available to the banks and investment banks — the primary dealers. It’s important that it does stay available,” Thain said to the audience at the Wall Street Journal dealmakers conference at the posh Pierre Hotel in Manhattan.
It had been widely assumed that the facility would be continued after its scheduled expiration in September. But recently opinions have shifted, with some reading the recent warnings from several Fed officials as indicating the window will be closed. What’s more, the investment banking community is said to be split on whether they should have continued access to the window. Goldman Sachs is said to be leaning toward opposing a move to make the borrowing facility permanent, and Lehman is said to support the move. Morgan Stanley reportedly takes a middle position, wanting to wait to see the kind of regulation that would accompany the window.
This is the first time we know of that a securities firm has gone on record with its support of keeping the window open. Thain’s decision to take this stance seems to indicate that he is taking seriously the idea that the Fed will not keep the facility open beyond September.
Merrill’s Thain Urges Fed To Extend Lending Deadline To Brokers [Dow Jones]
Merrill CEO wants ongoing Fed access, rules reform [Reuters]
Yesterday we interviewed an investment banker who thinks the Federal Reserve will permanently close the new facility for borrowing by investment banks when it expires in September. Michael Lewis says its too late, the impression that Wall Street’s biggest institutions are too big to fail has already taken hold and cannot be reversed. Regulation will surely follow.
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Bear Stearns
Is The Federal Reserve Going To Close The Investment Banking Window?
By John CarneyWidespread expectations that the borrowing window opened to investment banks in the midst of the Bear Stearns collapse last March will be made permanent may be misplaced, according to a longtime Fed watcher and banking expert we spoke with today. It may also explain why Lehman was so eager to shore up its balance sheet.
“All the talk coming out of the Federal Reserve about moral hazard and the unique situation we faced in March is meant to signal that the window will be closed,” he said over a bowl of gazpacho in a Soho restaurant.
The Federal Reserve is concerned that the widespread impression among Wall Street executives and investors that the Fed now stands behind investment banks may encourage excess risk taking, he said. Many are skeptical that further regulation could effectively stem risks, and fear that further entrenching the Federal Reserve in the financial system could endanger its independence.
Remarks made today by New York Federal Reserve Bank President Timothy Geithner seem to support this idea. “I know that many hope and believe that we could design our system so that supervisors would have the ability to act preemptively to diffuse pockets of risk and leverage,” he said. “I do not believe that is a desirable or realistic ambition for policy. It would fail, and the attempt would entail a level of regulation and uncertainty about the rules of the game that would offset any possible benefit.”
Lehman’s decision to raise $6.0 billion in new capital was driven in part by fear that the Federal Reserve’s borrowing window will permanently be closed to investment banks, he said. He believes the Fed has been quietly telling investment banks to expect the emergency borrowing facilities not to be renewed after they expire in September.
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Fed
Why Is The Federal Reserve Talking So Much About The Costs of The Investment Banking Backstop?
By John CarneyAlthough New York Federal Reserve Bank President Timothy Geithner said today that he supports the Fed’s moves to rescue Bear Stearns from bankruptcy, he went out of his way to emphasize that this was a response to an acute risk to the financial system.
“It was the only feasible option available to avert default,” he said. “We were not confident that the damage could be maintained by other means.”
The Federal reserve has been on something of a yakking rampage lately.
