Saturday, April 18, 2009

The Evaporating Collateral Of The United States

In a Bloomberg article today, Federal Reserve Vice Chairman Donald Kohn said that the central bank’s emergency lending programs aren’t creating a significant risk for U.S. taxpayers and went on to clarify that the major sense of security is prompted by the quality of the collateral pledged against these loans. To quote Kohn:
"We are not taking significant credit risk that might end up being absorbed by the taxpayer. For almost all the loans made by the Federal Reserve, we look first to sound borrowers for repayment and then to underlying collateral."
Citi is a sound borrower? Met Life is a sound borrower? Probably yes... if the soundness is determined by the joke that are the "stress" tests: everyone is all too well aware that all 19 stress testees will pass. How long they will survive after they "pass", especially once unemployment hits a possible high 20% (if corporate spreads are any indication) relative to the government's downside case in the 8-9% range, only time will tell.

(chart hat tip Richard)

The more relevant question is what is the true quality of the collateral that the Fed is willing to accept in exchange for providing taxpayer cash as loans to assorted institutions of all shapes and sizes. The data below demonstrates that as the credit crisis has progressed, the Fed has become willing to accept more and more risky collateral, with some of the most recent incarnations of the program essentially accepting any assets, including the toxic variety. As Zero Hedge has disclosed previously, the chart below demonstrates the various bailout programs (and key bailout players) sorted chronologically.

The dangerous thing here is that as time has evolved and the crisis has deepened, the Fed has become willing to accept much less sound assets as collateral, initially the default being safe US Treasuries (although with US Debt/GDP likely to skyrocket past 100% over the next several years, even this category can be perceived as risky), however the bar has subsequently dropped lower and lower to include first tier commercial paper, investment grade debt, and at the bottom of the rung: a full range of discount window collateral which includes, among others, residential and commercial real estate loans, CMOs, and corporate bonds.

Does this telegraph that the Fed, in loosening its high quality collateral standards, is anticipating expanding the bailout programs to a point where it is willing to accept not only HY bonds as collateral but outright equities? The last preposition is frightening, especially if there is any direct or indirect method that the Fed or the Treasury possess in order to manipulate equity price levels, as this would effectively translate into the biggest conflict of interest in history. But even assuming that conspiracy theories are too far-fetched for the purpose of this rational discourse, the declining collateral quality trend is very troubling. If eventually the system reaches a point where taxpayer money is collateralized by the investments (speculations) that these very same taxpayers (for the most part) invest in equities and other market securities, the circular logic of bidding up assets in order to prevent collateral quality from falling (and thus wiping out taxpayers) will become the de facto norm. In a way, this puts yet another twist in the ongoing bifurcation between U.S. taxpayers and U.S. investors who very often are the very same individuals.

The conclusion is that if one did not fear the "full faith" retaliation of the U.S. government, one would be tempted to define Kohn's statement as not only groundless cheerleading, but ultimately predatory disinformation dissemination. However, as we here at Zero Hedge observe our daily fear of the abovementioned phenomena, we would not go so far as to make that broad an assumption. Instead we will leave this topic as an open question, welcoming reader feedback, and hope to have provided sufficient food for thought as the U.S. economy deteriorates more and more from the consequences of the biggest credit unwind in the past 70 years.


One additional point with regard to reader feedback: commenting at Zero Hedge is meant to be an open forum for information exchange and discussions. However, an alarming trend is the observation of trolling by certain commentators, who abuse the above principle for the sake of populating comment threads with no meaningful benefit to anyone, and outright character attacks at times. This behavior will not be tolerated and individual IP addresses as well as entire domains will be banned from commenting without prejudice going forward. This is a first and last warning.
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