The Fed's Risky Backdoor Bailouts

As part of its effort to prop up the markets, the Fed is giving billions to banksand putting taxpayers at risk
Bernanke: The Fed currently has $2.2 trillion in outstanding loans Jonathan Ernst/Reuters

The U.S. Treasury Dept. has been blasted for handing out huge sums of money to banks without clear taxpayer safeguards or ground rules for the recipients. Yet the Federal Reserve is pouring trillions into banks with little transparency. The moves have helped to shore up the wobbly financial system in the short term. But some of the deals could end up hurting taxpayers, weakening the central bank, and weighing on the economy in the future.

In one of its latest transactions, the Fed in November channeled $20 billion—more than the size of the proposed auto bailout—to a group of U.S. and European banks, including Société (SCGLY), Deutsche Bank (DB), and Goldman Sachs (GS), according to people familiar with the deals. The only evidence that the vast sum had changed hands was an entry on the Fed's most recent balance sheet called "Maiden Lane III" and a series of cryptic regulatory documents.

By making loans to financial institutions that can't get credit elsewhere, the Fed is the only part of the government that has the power to pump capital quickly into the financial system to stave off crisis. Historically such moves have been rare, and they've been made behind a curtain of secrecy on the thinking that public disclosure could spark a market panic. "We keep these transactions private because the Fed, as a lender of last resort, seeks to provide liquidity and not stigmatize those who seek it," says Calvin Mitchell, a spokesman for the New York branch of the Fed, which set up the Maiden Lane III transaction.

The banks likely welcomed the fresh capital from Maiden Lane III. But in recent months the Fed has pushed the boundaries of its authority by taking larger and more opaque risks on its books. The central bank currently has $2.2 trillion in outstanding loans, up from $900 billion in September. It's also using new and untested weapons. Until this year the Fed mainly loaned to banks. Now it's buying securities, some tied to poisonous mortgages. If those bets don't pay off, the Fed will eat the loss.

dangers lurk

That could spell trouble for taxpayers—and the economy. If the Fed's new deals don't work out and the losses are too great, the central bank may have to print more money, flooding the financial system with dollars. Inflation could surge, making it harder for the Fed to focus on other objectives, such as economic growth. "We have to wonder if the Fed's balance sheet might be in danger," says Roy C. Smith, a finance professor at New York University's Stern School of Business. "It is legitimate to ask the Fed to defend [its actions]."

There are growing calls for more accountability of the government's far-flung bailout efforts. The Congressional Oversight Panel, which monitors how Treasury spends its $700 billion bailout pool, is closely watching the Fed's moves as well. Elizabeth Warren, the independent chair of the panel and a Harvard Law School professor, says that's because the Treasury's actions dovetail with those of the Fed. Warren recently met with Fed staff to discuss how the central bank spends taxpayer money. As part of the ongoing inquiry she is also looking at Treasury money that indirectly funded the Maiden Lane III deal. "There were good reasons the Fed was made independent of oversight," says Warren. But "these are not ordinary times, and the amount of money and intervention by the Fed is extraordinary."

The roots of Maiden Lane III can be traced to the Fed's rescue of troubled insurer American International Group (AIG) in September. With AIG on the brink of collapse, the Fed and Treasury stepped in to prevent a meltdown of the financial system.

Disentangling AIG from Wall Street has proved difficult, though, and the aid package has been expanded from $85 billion to more than $150 billion.

To stabilize the banking system, the Fed decided to quarantine some of AIG's riskiest holdings. Especially worrisome: the tens of billions of dollars' worth of insurance AIG had sold to banks on toxic mortgage securities. If those mortgage securities continued to fall in value and AIG couldn't pay out on the insurance, known as credit default swaps, the banks would lose desperately needed capital.

So the Fed created Maiden Lane III, an entity named after the location of the central bank's New York branch, to buy the assets from the banks and cancel the insurance. The Fed put in $15 billion of its own capital and took an additional $5 billion from AIG, which had received the money from Treasury. Maiden Lane used the $20 billion to purchase so-called collateralized debt obligations—the toxic mortgage securities that AIG had insured for banks—with a face value of $46 billion, paying 43¢ on the dollar. AIG also paid the banks $26 billion in insurance payouts on the CDOs.

"a good deal"

The result: The banks were paid in full for securities that were virtually impossible to sell in the marketplace. That strengthened their balance sheets, helping them to better weather the financial crisis in recent weeks. "It certainly seems like it was a good deal for the [banks]," Maurice R. "Hank" Greenberg, former chairman and current major shareholder of AIG, wrote in a letter to AIG management. AIG and the banks declined to comment.

But beyond the basic framework, little is public about Maiden Lane III. Société, Deutsche Bank, and Goldman Sachs received money, but the Fed didn't disclose how much each got. And the list of recipients is likely longer than those three banks. Nor does the Fed offer any clue about the composition of the 100 or so CDOs it now owns. An exhibit in a Dec. 2 regulatory filing by AIG provides most of the specifics, but AIG only makes public a heavily redacted version.

The few known details about Maiden Lane III raise questions about the Fed's risk-taking. The central bank usually makes short-term loans that the borrower must repay within a few months. In this case, the Fed will recoup its capital on the CDOs only if the securities pay off or can be sold to outside investors. That's a dicey bet. Merrill Lynch (MER) sold similar securities last summer for just 22¢ on the dollar. Since then, the housing market on which they're based has deteriorated even further.

The anxiety could grow if the central bank remains silent. "If the Fed doesn't want to give us the specifics, they should tell us something that makes us comfortable that they are properly capitalized and not presenting an undue risk to the financial system," says veteran Fed watcher Jim Bianco of Bianco Research. "The integrity of the Fed is in play here."

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