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Fed Let Brokers Turn Junk to Cash at Height of Financial Crisis

Fed Let Brokers Turn Junk to Cash, Height of Crisis
The U.S. Federal Reserve building stands in Washington, D.C. Photographer: Joshua Roberts/Bloomberg

At the height of the financial crisis, the Federal Reserve allowed the world’s largest banks to turn more than $118 billion in junk bonds, defaulted debt, securities of unknown ratings and stocks into cash.

Collateral of those asset types made up 72 percent of the total $164.3 billion in market-rate securities pledged to the Fed on Sept. 29, 2008, two weeks after the bankruptcy of Lehman Brothers Holdings Inc., according to documents released yesterday. The collateral backed $155.7 billion in loans on the largest day of borrowing from the Primary Dealer Credit Facility, which was created in March 2008 to provide loans to brokers as Bear Stearns Cos. collapsed.

“The fact that the Fed was willing to accept that collateral was indicative that collateral was very hard to come by at the time,” said Craig Pirrong, a finance professor at the University of Houston. It also highlights “the seriousness with which the Fed viewed the situation,” he said.

Fed spokesman David Skidmore declined to comment yesterday. No public money was lost in the Fed’s emergency lending programs, Chairman Ben S. Bernanke testified to the Senate Banking Committee in July, 2010. The loans didn’t represent permanent cash given to the dealers and had to be repaid the next day.

The Fed loans on Sept. 29, 2008, represented a 5.49 percent “collateral cushion,” the amount by which the pledged assets exceeded the loan value, according to the Fed data. Equities comprised $71.7 billion, or 43.6 percent of the total. High-yield debt, including the defaulted issues, accounted for $18.4 billion, or 11.2 percent. Collateral of unknown rating was $28 billion, or 17 percent.

High-yield, high-risk bonds are rated below Baa3 by Moody’s Investors Service and lower than BBB- by Standard & Poor’s.

Index Fell

The S&P 500 index fell 8.8 percent on that day.

“To put things in perspective, the market haircut on most debt securities during the period of the crisis starting in September 2008 was above 40 percent,” Pirrong said.

The U.S. central bank allowed borrowers to use $929 million in market-valued debt that had gone into default, rated D, as collateral on that day, 2008, more than the $905.5 million in Treasuries that were pledged, according to the Fed documents. The documents released yesterday included the most detailed view of collateral to date for the facility, which operated from March 16, 2008 to Feb. 1, 2010.

Small Cushion

The cushion “was far too small for the risk of the underlying collateral,” Pirrong said. “Collateral that’s junk or defaulted debt and equities at a time when market volatility was huge is pretty eye opening.”

The amount the Fed discounted based on the specific asset classes like the defaulted debt or equity collateral can’t be determined by the data released yesterday.

Morgan Stanley was the largest borrower on Sept. 29, 2008, totaling $61.3 billion, the data show. The New York-based firm pledged $66.5 billion in collateral, including $21.5 billion in equities, $19.4 billion in unknown rated securities and $6.7 billion in junk or defaulted debt.

Mark Lake, a Morgan Stanley spokesman, didn’t immediately return a call for comment.

Merrill Lynch was next, with a $36.3 billion loan. Its $39.1 billion in collateral included $23.3 billion in equities, $6.3 billion in unknown rated securities and $3 billion in junk or defaulted bonds.

Jerry Dubrowski, a spokesman for Bank of America Corp., which bought Merrill Lynch in 2009, declined to comment.

Recourse Loans

The loans extended to primary dealers under the PDCF by the New York Fed were recourse loans, meaning the potential liability of borrowers who defaulted was greater than the value of the collateral pledged, according to the Fed.

In September 2008, as Lehman Brothers was on the brink of filing for bankruptcy, the PDCF was expanded to accept all types of collateral pledged in tri-party repo deals. In such transactions, a third party functions as the agent between borrower and lender, holding the collateral, which the borrower repurchases at a later date.

Acceptable collateral for the Fed’s dealer facility expanded from only investment-grade debt securities to include high-yield, high-risk securities and equities.

“Our broad-based programs achieved their intended purposes with no loss to taxpayers,” Bernanke told lawmakers last year. “All of the loans extended through the multi-borrower facilities that have come due have been repaid in full, with interest.”

Thousands of Pages

The Fed released thousands of pages of secret loan documents under court order, almost three years after Bloomberg LP first requested details of the central bank’s unprecedented support to banks during the financial crisis.

The records -- 894 files in PDF form with 29,346 pages -- reveal for the first time the names of financial institutions that borrowed directly from the central bank through the so-called discount window. The Fed provided the documents after the U.S. Supreme Court this month rejected a banking industry group’s attempt to shield them from public view.

Bloomberg News is posting the raw documents here for subscribers to the Bloomberg Professional Service as well as online at Accessing them will take several minutes.

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