What the FED accepts as collateral these days

Ilargi: The following is from a discussion at one of Karl Denninger's forums at his site, Ticker Forum. I think it's an important one, so I decided to select the "most relevant" bits, in my view, and post it here. I highly recommend a regular look at Karl's forums, and his site, there's a lot of good quality information there.

In the next few days, you are likely to see people write about an FDIC document named Processing Deposit Accounts in a Bank Failure, dated January 14, 2008, that many think is a harbinger of large scale preparations for mass bank runs. I have looked at the document, and I doubt that judgment, as do Stoneleigh, and Karl. There is some talk about what banks do with their sweeps that might be potentially hurtful for depositors, but it's not crystal clear that it would.

A potentially far more damaging FDIC document is one that circulates on the net in recent days, though it dates back to November 19, 2003: Advisory Committee on Banking Policy, Minutes of Meeting, which contains these by now famous words:

Through her research, she advised, she was fascinated to learn about the FHLBs' "super lien" against the assets of banks to which they make advances. These rights, she added, including prepayment fees, are provided by statute and are superior to the rights of depositors and even to the FDIC after an institution fails.

As we have reported before, this last document spells out that in case of bank failures, the Federal Housing Loan Banks are first in line for what is left of a bankrupt bank's assets. Only after that, the depositors might be able to claim their money.

But to get back to the issue at hand, here's the TickerForum discussion. The premise is this: The Fed loans money to banks, through the discount window, and through its Term Auction Facilities (TAF's). Two weeks ago we reported that banks' non-borrowed reserves had gone negative, and by now some people are starting to wonder what the Fed deems acceptable as collateral for all those loans. The answer looks somewhat surprising.


A look at FED Collateral Requirements

Lakeshorelady:

There has been a question in few threads asking if anyone had found the FED collateral requirements. Well I stumbled upon it. The link below shows the collateral requirements specific for DW borrowing (I know the same collateral requirements are being used for TAF but I don't know if this is also the requirements for reserves) The info is availiable in both Excel and PDF.

Basically they will take anything, it is quite alarming. All that junk wrapped by the monolines is the FED's collateral. Bernanke --- sold to you.

One can see from the tables (info straight from the FED) that the collateral requirements are extremely liberal and even consider prior value. For example, with a liquid CDO, the Fed will lend up to 98% if it's a short-term CDO, up to 96% if it's medium-term, and up to 93% if it's long-term. If the CDO lacks liquidity in the market, the Fed will still accept it and lend up to 85% of its par value.

They will even take AAA-rated subprime-backed CDO (junk wrapped by the monolines) and subprime creditcard account receivables. Here is the link -- just choose between Excel or PDF format

Discount Window and PSR Collateral Margins Table

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Darknite:

AAA Muni bonds are rated = to Mortgage back securities. I’m sure there is no risk difference at all, although the market seems to think there is.

Interesting, at the bottom of the report it shows that loans held directly by the bank are worth 10% less as collateral than a securitized loan. The FED is encouraging the packaging of loans to be sold as tranches. This feeds the insurance game (mbia/Ambac) and the derivatives game.

The FED is not concerned about the casino, HELL THEY ARE RUNNING IT!

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Lakeshorelady:

Exactly -- the way the TAF came to be makes me view TAF as the "silent" bailout

Here's a question -- When the FED accepts these mortgages as collateral, what happens when the loans go into default? Does the FED "own" them -- Can they demand an exchange of collateral from the entity that placed them up as collateral or does the FED become the "trustee" in the foreclosure proceedings?

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Darknite:

I have an idea:.

From the FED: Release Date: August 17, 2007

“The Board is also announcing a change to the Reserve Banks' usual practices to allow the provision of term financing for as long as 30 days, renewable by the borrower. These changes will remain in place until the Federal Reserve determines that market liquidity has improved materially. These changes are designed to provide depositories with greater assurance about the cost and availability of funding.”

Lending by the FED was to be short termed, 10 days or less? Activity with borrowing by banks is high. The FED stabilizes the scramble for funds by lengthening the term and they lower the rate (thus the cost of funds) to slow the bleeding. Banks use the borrowed funds to shore up capital, generate new business if they can, and liquefy the system so activity (clearing paychecks, CC, buying transactions, ect.) can continue. If they don’t clear checks or have wires happen with extra days, people freak.

The treasure curve is short term inverted and the long spread is not enough for the banks to borrow from the FED and buy treasuries and heal, like 2002-03, so the banks and FED options are running out and so is time.

If you look at the Federal Reserve System Discount and PSR Collateral Margins Table* all the collateral MUST BE AAA! This is another reason the insurance companies are critical. Some portion of the FED’s collateral will not meet their standard. Would they not recall the loans? Banks go TU right now. I do not think this angle has been considered. This would be an OH SHIT MOMENT!
Your thoughts?

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Lakeshorelady:

After processing just how deep in the system the dependence/pressure of the issurers maintaining a AAA lies, it really frightens me to think what will result secondary to downgrade. It isn't just some of the banks and entities on Wall Street that could face instant insolvency but the Federal Reserve too. Thinks makes me more convinced that some sort of a plan will be launched to support the monolines regardless of the extreme moral hazard consequence.

It is a lesser of 2 evils choice that 2 rating agencies face -- A) complete moral hazard with civil liability or B) complete failure which could easily include the Treasury. I am sure if they pick A they will be "protected some"

I know all of the above may sound tinfoil but think it through. The Federal Reserve is lending all of the Treasury market out using subprime debt insured by bankrupt monolines. I wish it was tinfoil.....

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Darknite:

The hubris and irony of the system these “geniuses” created is what gets me. Insurance seems like a good idea. Who does not want insurance? Why, just in case, for a rainy day, put away a little and build up a nest egg so when the time comes, as it invariably does, one would be ready. This confidence insurance creates gives rise to lower rates for all borrowers and spurs on economic growth and prosperity for all. BUT, insurance, the guarantee, is only as good as who or what stands behind it.

Now the TSHTF and the insurance, well there is only $1 for every $10 insured, perhaps less. As we have come to find out, the operators are drunk with power and oblivious to the systemic thread they gave birth to. The lowering of risk has raised the betting at the table, "DOUBLE DOWN, WE CAN"T LOOSE! ... OH SHIT..." The Pigmen may save the system for now, but it must be taken apart, or it will fly apart and take a lot of people with it.

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Genesis

The problem with an "AAA" rating is that "AAA" means "equal to the debt of the US Federal Government."

That's the DEFINITION of "AAA". In fact, the default risk is something on the order of 0.02% over ten full years when looking at the statistical normal distribution. In other words, lost in the noise - you can treat it as physical cash. Well, none of this crap is, and that's the problem.

Monoline insurance of munis was and is a license to print money, because munis are VERY conservatively rated to start with and getting the credit enhancement is thus cheap in real terms - you can mark it up, make a nice profit, and the number is still small enough to be worth it. This, however, is why munis pay less coupon than Ts in a normal market - that cost has to be paid for.

This is balanced by the tax-free treatment of munis..... Well, now the apple cart has been upset.....

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Late-to-the-party

The problem with an "AAA" rating is that "AAA" means "equal to the debt of the US Federal Government."

Sure ABK/MBIA have a (ever so slightly) higher chance of defaulting on their debts than the US government, and sure they don't DESERVE a AAA rating, but why does that mean the rating agencies MUST downgrade them? Is there any law of man or nature to compel them to act if the powers that be are publically calling on them to hold off?

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Genesis

Fiduciary responsibility and their own published statements of operating principles.

People rely on those ratings and while the agencies have so far hidden behind a "we're a publisher and this is an opinion" defense (First Amendment) that defense will fail spectacularly if they make intentionally false statements

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Late-to-the-party

Quote:
Fiduciary responsibility and their own published statements of operating principles.

People rely on those ratings and while the agencies have so far hidden behind a "we're a publisher and this is an opinion" defense (First Amendment) that defense will fail spectacularly if they make intentionally false statements.

All very true.

Here's my concern: the insurers need $30B each to stay capitalized and maintain their AAA ratings, and nobody is willing to/has the cash to bail them out. However, the real issue here isn't the capitalization (or even solvency) of ABK/MBIA, it's the rating they carry. Doesn't it amount to a free bailout if regulators just look the other way while the raters stall indefinitely? What DA is going to prosecute them knowing it will precipitate a financial meltdown? If this is about self preservation, who cares about the harm it causes investors? RIP moral hazard.

As a side note: to whom do the raters' owe their fiduciary responsibility--aren't their principals the issuers and not the investors who rely on the ratings?

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Nothing

What I don't get is...what makes [real estate] special? Folks have been walking away from debt service and leaving collateral behind since debt was invented. That's the whole idea behind "Security"

The only folks who should be getting their knickers in a bunch is the debt merchants who made the bad bet and now have to pay the piper.

and...it's a damn sure bet the folks who loaned the debt merchants the money, they pissed away, are going to make sure they get it back at par[..], or Hell will freeze over before they ever get another penny.

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Lakeshorelady

Okay,
Found more on the FED site. These loans are done at PAR value, no mark to market. So a subprime loan that is under 60 days late (see below) will be accepted at 85% of its par value. Very funny as the RE market has plummented and most of the subprime loans have blow out appraisals on top of it -- I would venture most of the mortgages the FED has as collateral are upside down. Also they can "roll" after 30 days with no other mark to market to the collateral. It is all on the FED site.

That's right folks === consumer loan payments do not have to be current to be acceptable collateral. Also says the collateral must be in a form that the FED can liquidate should they need to.

Seems the FED is willing to take collateral noone else will so what do you think they are getting? The top of the barrel or the bottom.

2.3 Unacceptable Types of Assets

• In determining whether collateral is acceptable for the Discount Window, the Reserve Bank will consider assets that meet regulatory standards for sound asset quality and other associated risks. It will not accept assets that: (1) are subject to adverse regulatory classification; (2) are 30 days or more past due (60 days for mortgage notes and other consumer debt, including student loans); (3) are illegal investments for the pledging institution; or that (4) exhibit collateral and credit documentation deficiencies.

Considering there is no limit in how many times the 30 day TAF loans can be rolled, there is no collateral mark to market (loans accepted at par with FED margin applied), there is no collateral mark to market on a TAF "roll", mortgages are acceptable as long as they are less than 60 days late, collateral will be submitted in a form that can be liquidified by the FED, TAF will continue until determined by the FED it is no longer needed, and TAF borrowers are not public -- it smells like a bailout to me.

Oh, one more thing -- the FED does not make an income of the loans that are held as collateral the entire time the FED holds them, the "borrower" stil gets all that --

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