Scrambled Egg Turns Fed Into Prime Broker

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Federal Reserve officials are gathering around the broken loan securitization market the way all of the king’s men once gathered around Humpty Dumpty. They’re trying to put back together the once dandy shadow banking system, the one that just a few years ago former Fed chairman Alan Greenspan praised for its ability to efficiently raise new capital and disperse risk. It is a messy and daunting task, but Fed officials have got to try because more than half of lending was being financed by this big Wall Street creation. Unless securitization is put back together, it will be a long, long time before the credit crunch lets go of the economy.

For a sense of how the Fed is trying to put things back together, take a look at its release Friday of additional terms and conditions for its Term Asset-Backed Securities Loan Facility, the so-called TALF. The posted details, including explanations among a long list of “frequently asked questions,” run to more than 7,000 words, according to my word processor. (You can apply your own multiple of 7,000 to estimate how many words the lawyers will put into the actual contracts.)

The facility is so complicated because the Fed aims to use the TALF to fuel a return of loan financing by non-bank entities, such as small finance companies and hedge funds. One step toward doing that is to, more-or-less, operate a prime brokerage for hedge funds the way Wall Street used to do in a big way. In the credit boom, Wall Street’s prime brokerage units lent lots of money to hedge funds to buy asset-backed securities, such as notes and bonds issued by pools of mortgages, car loans and credit card receivables. Now Wall Street is battered, short of capital and not lending so that others may lend. The Fed is stepping in with as much as $200 billion, probably later this month. This means the Fed is now quoting loan rates, deciding which asset-backed securities it will accept as collateral, and dealing with hedge funds.

Of course, the prospect of dealing with hundreds of barely-regulated hedge funds makes the Fed vulnerable to fraud. The Fed, after all, is used to dealing with banks it regulates and with big banks that have qualified as primary dealers of U.S. Treasury securities. The Special Inspector General for the Troubled Asset Relief Program (TARP) highlighted the fraud threat in a report to Congress dated Feb. 6, the same day the Fed posted the many details about its TALF terms. (The inspector general took up the topic because TARP money is going into TALF.) The result is that the Fed is under pressure to carefully make loans and at the same time quickly spread money all around to revive securitization.

It would have been so much easier if the Fed had kept Humpty Dumpty from losing his balance in the first place.

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