Tuesday, November 25, 2008

Fed Unveils New Lending Facility

From Marketwatch:

The Federal Reserve on Tuesday unveiled its new Term Asset-Backed Securities Loan Facility (TALF), a plan under which it will lend up to $200 billion to support the issuance of debt backed by consumer and small business debt like credit card loans, student debt, auto loans and loans backed by the Small Business Administration (SBA). The Fed hopes the plan will create liquidity in the market for securities backed by the receivables from such loans, which in turn would encourage originators of consumer loans to restart lending to individuals.

But that's not all:

The central bank will purchase as much as $600 billion in debt issued or backed by government-chartered housing-finance companies. It will also set up a $200 billion program to support consumer and small-business loans, the Fed said in statements today in Washington.

What the Fed is trying to do is jump-start the securitization market for consumer debt. When a credit card company issues a certain amount of cards, it takes the accounts and securitizes them much in the same way mortgages are securitized. However, the entire credit market has seized up, including the consumer market. As a result consumer credit issuance is tight.

But with this new lending facility comes added stress on the Fed. Consider the following points from this week's Barron's:

IF THE FEDERAL RESERVE BANK WERE A COMMERCIAL LENDER, it would be a candidate for receivership, based on its capital ratios. Bank examiners generally view any lender with a ratio below 2% to be dangerously undercapitalized. The Fed's current capital ratio, or capital as a percentage of assets, is 1.9%.

The Fed has provided so many loans and emergency credits -- to banks, brokers, money funds and foreign countries -- that its balance sheet, viewed one way, is as leveraged as any hedge fund's: Its consolidated assets amount to 53 times capital. Only 11 months ago, its leverage on this basis was a more modest 25 times, and its capital ratio 4%. A caveat: Many of the loans are self-liquidating facilities that will disappear in a few months if the financial crisis eases.

Although the Fed's role as a central bank is much different from the role of a private-sector operation, the drastic changes in the size and shape of its balance sheet worry even some long-time Fed officials. Its consolidated assets have swelled to $2.2 trillion from $915 billion in about 11 months, and contain at least a half-dozen items that weren't there before. Some, like a loan to backstop the purchase of a brokerage, Bear Stearns, are unprecedented. (See table for highlights.)

Critics say this action could hinder the Fed in achieving its No. 1 priority: keeping inflation in check. To try to get in front of the crisis, many decisions have had to be made on the fly.

"If the Fed had been [a savings-and-loan] ballooning its balance sheet so fast, the supervisors would have been all over it," says Ed Kane, a Boston College finance professor.

Here is an accompanying graphic:

Click for a larger image

While these are extraordinary times, that does not mean conventional rules of risk management do not apply in one way or the other.