As reported by The Wall Street Journal, one of the more remote contingencies the Federal Reserve has considered is a mirror image of the Term Securities Lending Facility: it would take the mortgage backed securities pledged to it by dealers in return for Treasurys; then repledge them to other dealers, taking Treasurys back. Since the Fed is highly unlikely to fail, dealers might be more comfortable accepting MBS as collateral from the Fed than from other parties. But this might be complicated to do if the MBS are held by a custodial bank as is typical in a triparty repo.
Lou Crandall of Wrightson Associates thinks it’s cool idea. His thoughts:
I’ve been discounting the inflated Treasury borrowing option a little bit because the traditional legal view at Treasury has been that the Secretary’s borrowing authority only extends to financing Congressional appropriations. (They cited legal objections last summer when they were urged to pump up their borrowing and put the money back into the [Treasury Tax and Loan] system last summer as a way of providing support.) Running a banking business is frowned upon. I don’t doubt that [Treasury Secretary Henry] Paulson could persuade the Treasury’s lawyers to rethink their position if absolutely necessary, but it would be a lot cleaner to go to Congress for authority to create a larger warehouse for financial instruments.
The reverse swap is intriguing because it is sufficiently exotic that it might sidestep some of the traditional legal issues. My hat is off to whoever thought of it. That is one option that hadn’t occurred to me.
After a quick first reading, it sounds to me as if the idea would be to take the triparty collateral and put it back into the market with a Fed seal of approval. The curious thing about recent repo market disruptions is that counterparties have started caring more about the counterparty than the collateral because nobody wants to be caught up in the uncertainty of a bankruptcy. If the Fed were on the other side, the counterparty risk component would fade away in an MBS repo. [LOL, no sh*t–ed] That’s so creative/outside-the-box that I hesitate to simply assume that’s what the Fed is talking about.
The Fed could provide guarantees in the financing market that would substantially expand its balance sheet resources through the equivalent of a matched-book operation. With sufficient leverage, they could revalidate a huge range of privately-financed mortgage debt. I’m not sure they should or could legally, but it is really interesting and worth chewing over.
For what it’s worth, I really do think this is an idea that would be worth pursuing if the Fed were faced with an emergency need to provide funding through the discount window. …
Conclusion one: Never hire “Wrightston Associates” for anything. This guy is a complete moron.
Conclusion two: The Fed believes that the best way to “solve” this mess is to do the exact same thing that the banks did — put its own name behind an obligation that is fundamentally worthless.
That’s what got us into this mess into the first place.
The only reason the Fed’s guarantee is any better than a private bank’s is that the Fed has the power to create money.
So it will be perceived to be committing to create money in the future, even if no actual money-creating takes place in terms of the Treasuries and MBS on the balance sheet.