Fed Loans Hatched in Bathroom Halted Money-Market Run
Deborah A. Cunningham, the manager of $261 billion at Federated Investors Inc., was squeezed into the bathroom of her family’s recreational vehicle, trying to help save the $3.6 trillion money market industry.
Cunningham was on the phone with Federal Reserve officials in Boston, New York and Washington. Outside, in the Pennsylvania State University stadium parking lot in State College, football fans were preparing for a game against Temple University.
“It was the only place I could hear,” Cunningham said. “People were drinking beer. They kept knocking on the door, saying, ‘I have to go.’”
The solution Cunningham helped craft on Sept. 20, 2008, was a bailout for money market funds, which were created as safe investments that could be easily cashed out. The Fed put the facility into effect two days later. At its peak in October 2008, it provided $152 billion to stem a customer run sparked by the Sept. 15 bankruptcy of Lehman Brothers Holdings Inc.
This week’s disclosures of data from the Fed’s rescue efforts during the 2007-2008 financial crisis show how the central bank employed companies to help design or run programs they could use to their benefit. Federated tapped the money- market rescue for $8.89 billion, according to Fed data. Pacific Investment Management Co. and BlackRock Inc. weren’t only advisers to the Fed, they were also trading securities they helped value, the Fed data show.
“That’s the way the system works,” said David Castillo, senior managing director at Further Lane Securities in San Francisco. “It’s problematic that they’re customers, but that shouldn’t limit their ability to participate in this process. Quite frankly, we don’t have a choice. They have the expertise.”
In compliance with the Dodd-Frank financial overhaul law, the Fed on Dec. 1 identified the institutions that used $3.3 trillion of improvised rescue programs. The 21,000 transactions in 11 initiatives included the money-market plan Cunningham helped devise, known as the AMLF, short for its 10-word formal name, the Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility.
In its scramble to keep the economy from collapsing, the Fed also created the Commercial Paper Funding Facility, or CPFF, which tried to ensure that banks and industrial companies had the short-term loans they needed to fund everyday operations. General Electric Co., then the biggest issuer of commercial paper, met with Treasury and Fed officials in the days before they created the CPFF.
Later, the Fed set up the Term Asset-Backed Securities Loan Facility, or TALF, to keep consumer credit flowing. It hired Pimco, manager of the world’s largest bond fund, and BlackRock, the world’s biggest money manager, to provide analytical help, according to a November 2010 report by the Fed’s Office of Inspector General.
“Any situation where the potential exists for a conflict of interest is concerning,” said Kurt Bardella, spokesman for Representative Darrell Issa, the California Republican who will become chairman of the House Oversight and Government Reform Committee next month. “This really brings into focus one of the unintended consequences of institutionalizing the federal government picking winners and losers while those entities are partaking directly and indirectly in what should be exclusive government functions.”
Breaking the Buck
Cunningham was making calls from her camper’s restroom after the Lehman Brothers bankruptcy filing panicked investors, who pulled $230 billion from money-market accounts. The $62.5 billion Reserve Primary Fund, which held $785 million of loans to Lehman Brothers, became the biggest money-market fund and the first in 14 years to “break the buck,” meaning the value of a share fell below $1 and investors faced losses.
Money funds were the main buyers of commercial paper. During the panic, they had to sell off assets to pay investors who demanded their money back. That meant they couldn’t buy the commercial paper that corporations needed to pay for things such as payroll and utility bills. In less than a day, the credit crunch had spread to industrial companies.
By Wednesday, Sept. 17, officials at the Fed and the Treasury Department were focused on finding a solution for money funds, says Phill Swagel, who was assistant Treasury secretary for economic policy.
Swagel testified to Congress that morning on the deteriorating housing market and returned to the Treasury building around midday, he said. After eating a tuna sandwich, he was on conference calls with Fed officials the rest of the afternoon and late into the night.
‘Not Normal Policy’
Two days later, on Sept. 19, the Treasury announced that for a fee it would insure money market funds against investor losses.
“It’s not normal policy to say this asset class is now guaranteed,” said Swagel, a professor at Georgetown University’s McDonough School of Business in Washington, in an interview. “When there’s a run on money market mutual funds, there’s no time to do anything else but say they’re all guaranteed, we’re done.”
While the Treasury measure slowed the pace of withdrawals, it didn’t help money-market funds turn assets into cash fast enough to pay investors who wanted out. Putnam Investments LLC closed its $12.3 billion Putnam Prime Money Market Fund on Sept. 17 after investors asked for about a third of the fund’s money. Managers of the Boston-based firm faced the prospect of selling assets in a distressed market, which would cause the fund to break the buck.
Federated’s Fund Takeover
Cunningham’s Federated, based in Pittsburgh, was prepared to take over the assets of the Putnam fund, issuing investors shares in its $22.1 billion Prime Obligations Fund, she said. To make the takeover work, Federated needed to pay off all the Putnam investors who’d demanded their money, she said. For that, she turned to the Fed.
“We had been working with them trying to figure out what might work to add liquidity to the marketplace,” Cunningham said in an interview.
The AMLF, the bailout that Cunningham helped design, provided cash for banks to buy asset-backed commercial paper from money market funds. This made it possible for the funds to avoid selling at a discount, and the Fed agreed to take the risk of defaults, guaranteeing a profit for the banks when the loans were repaid.
‘Single Most Successful’
Without the program, it would have been “very difficult” for Federated to absorb the $12.3 billion in assets of the Putnam fund on Sept. 24, 2008, according to spokeswoman Meghan McAndrew. About half the investors redeemed their shares within a week, she said. That meant the deal brought Federated, the third-biggest U.S. money market company, about $6 billion in assets at no cost.
Federated’s Prime Obligations Fund now holds $47 billion of assets, more than double the amount before the transaction. In a deal announced July 16, Federated will pay as much as $38.8 million over five years to acquire $17 billion in money fund assets from SunTrust Banks Inc.
“Even if the entire Putnam fund redeemed, we were still confident with this facility behind us that there was liquidity in the marketplace and the ability to withstand that,” Cunningham said. “Putnam investors were immensely aided by this program. It didn’t really help Federated except for some positive press.”
All AMLF loans have been repaid, and the facility generated $543 million in interest, according to a Fed report.
“The AMLF was the single most successful government intervention during the financial crisis,” said Peter Crane, president of Crane Data LLC, a money-fund research firm in Westborough, Massachusetts, in an interview. “In a crisis when you have esoteric corners of the market involved, you have no choice but to go to the experts, and the experts will be self- interested players.”
While the AMLF helped stabilize money funds, they didn’t start buying commercial paper again. That left issuers without their biggest group of customers and unable to roll over short- term debt as it matured. At 5:45 p.m. on Monday, Sept. 15, GE Chief Executive Officer Jeffrey R. Immelt met for half an hour with Treasury Secretary Henry M. Paulson Jr. in the secretary’s office, according to Paulson’s schedule.
An hour and 15 minutes later, Federal Reserve Bank of New York President Timothy F. Geithner convened a staff meeting to focus on “GE issues,” according to his schedule. He and Paulson conferred by phone afterward.
On Oct. 1, Geithner’s schedule noted a tentative conference call with Immelt, who was a board member of the New York Fed, a position he still has today. GE spokesman Gary Sheffer said the company doesn’t see a conflict with Immelt’s membership on the New York Fed’s board. He declined to comment on the content of Immelt’s conversations.
Less than a month later, the Fed created a bailout of the commercial paper market. A special entity called CPFF LLC, funded by the Fed, bought commercial paper from companies. They included GE, which tapped the facility 12 times for $16.1 billion, the Fed disclosed this week.
Assistance to companies, which also included Toyota Motor Corp. ($4.6 billion), Harley-Davidson Inc. ($2.3 billion) and Verizon Communications Inc. ($1.5 billion), topped out at $348.2 billion on Jan. 21, 2009, according to the Fed. The program had no defaults and gained $6.1 billion in interest and fees, the central bank’s Inspector General said in its report.
Creation of TALF
In November 2008, the Fed set out to revive the market for bonds backed by consumer and small business loans. That market froze as an unprecedented number of defaults made assets backed by mortgages impossible to value. Wall Street had fueled lending by bundling mortgages into bonds using an innovation known as securitization.
“We were pretty confident that banks didn’t have the capacity to essentially replace the capacity that was lost in the securitization market,” said William C. Dudley, who headed the New York Fed’s Markets Group at the time and is now the bank’s president, in an interview. “We thought the best way forward would be to try and restart the securitization market, rather than just sit back and rely on the banking sector.”
On Nov. 25, 2008, the Fed created the Term Asset-Backed Securities Loan Facility, or TALF, which allowed investors to borrow from the Fed as much as 95 cents of every dollar invested in Fed-approved asset-backed securities. Investors also retained the option of turning the securities over to the Fed if they fell in value.
The New York Fed hired Pimco, based in Newport Beach, California, to value collateral, monitor the credit risk of TALF participants and assess the securities market, according to the Inspector General’s report. BlackRock Solutions, a unit of New York-based BlackRock, said it was brought on to supply analytical help on the securities.
Without singling out any contractors, the Inspector General’s office said that farming out certain tasks creates the potential for conflicts of interest.
“If you knew the inner workings of the third-party reviewer, you’re mitigating an incredible risk,” said James Harrington, who oversaw TALF investing at his former employer, Ryan Labs Asset Management in New York. Investors were required to buy securities without knowing whether the Fed would accept them for the program. The value of bonds rejected by the Fed would often fall. “If you knew that what you were submitting had a better chance of getting accepted, you’d know where the boundaries of the playground were,” Harrington said.
Pimco and BlackRock also participated in TALF as borrowers on behalf of clients, along with other financial companies. Pimco tapped TALF 96 times between April 2009 and March 2010 for a total of $7.26 billion, according to Fed data. Ten funds connected to BlackRock Financial Management Inc., another unit of BlackRock, borrowed a total of $2.8 billion for clients, the Fed disclosed.
On the first day of the program, Pimco put up $22 million and borrowed $292 million from the Fed to buy $314 million of bonds backed by Ford Motor Co. auto loans. The fund borrowed from the Fed at the London interbank offered rate plus 100 basis points, or 1 percentage point, and purchased securities yielding Libor plus 250 basis points, or 2.5 percentage points. The return was about 23 percent a year for investing in securities with the highest credit ratings and a Federal Reserve backstop.
The Pimco advisory team serving as a TALF collateral monitor for the New York Fed is subject to “strict physical, ethical and technological walls” and has no involvement in any investment strategies or decisions, said Mark Porterfield, a Pimco spokesman.
‘We Have Concerns’
BlackRock also participated in the initial Ford deal, purchasing $275 million of the same securities as Pimco, using $256 million borrowed through TALF, according to the Fed. Since February, when BlackRock Solutions was hired, BlackRock Financial Management borrowed $248 million to invest in a total of 13 commercial mortgage-backed securities deals.
There was no impropriety in BlackRock’s actions, said Bobbie Collins, a BlackRock spokeswoman. BlackRock Solutions was a collateral monitor providing analytical services for TALF, while BlackRock Financial Management tapped the program on behalf of clients, she said. The two units are separate businesses with strict information barriers in place, she said.
Firms helping to price hard-to-sell assets could overvalue them to raise the value of their own assets or those of their clients, said Michael Smallberg, an investigator with the Project on Government Oversight, an independent Washington watchdog group.
“We never found anyone maliciously trying to take advantage of taxpayers,” Smallberg said. “But we have concerns about how well those firewalls work.”
The New York Fed “has carefully managed potential conflicts of interest” in TALF, including separating workers, approving staff, restricting personal investments and conducting on-site audits of the controls, said Deborah Kilroe, a bank spokeswoman.
The Inspector General’s report, five months after TALF closed to new investment, said “a third-party vendor” under contract with the New York Fed’s legal group was “performing a conflict-of-interest review and testing compliance with contract provisions.”
Neither Pimco nor BlackRock has been accused of wrongdoing. The firms didn’t establish policies or approve or reject collateral, according to the Fed.
“It seems clear that the biggest beneficiaries were the insiders,” said Dean Baker, co-director of the Center for Economic and Policy Research in Washington. “We have a huge pinata here. The question is whether we had insiders deciding who would get the candy or was everyone in the same boat? Think of the people who get upset about the government giving a homeowner some help. Now multiply the sums by about 100 million. We should care.”