The Evaporating Collateral Of The United States

In a Bloomberg article today, Federal Reserve Vice Chairman Donald Kohn said that the central bank’s emergency lending programs aren’t creating a significant risk for U.S. taxpayers and went on to clarify that the major sense of security is prompted by the quality of the collateral pledged against these loans. To quote Kohn:

“We are not taking significant credit risk that might end up being absorbed by the taxpayer. For almost all the loans made by the Federal Reserve, we look first to sound borrowers for repayment and then to underlying collateral.”

Citi is a sound borrower? Met Life is a sound borrower? Probably yes… if the soundness is determined by the joke that are the “stress” tests: everyone is all too well aware that all 19 stress testees will pass. How long they will survive after they “pass”, especially once unemployment hits a possible high 20% (if corporate spreads are any indication) relative to the government’s downside case in the 8-9% range, only time will tell.


(chart hat tip Richard)

The more relevant question is what is the true quality of the collateral that the Fed is willing to accept in exchange for providing taxpayer cash as loans to assorted institutions of all shapes and sizes. The data below demonstrates that as the credit crisis has progressed, the Fed has become willing to accept more and more risky collateral, with some of the most recent incarnations of the program essentially accepting any assets, including the toxic variety. As Zero Hedge has disclosed previously, the chart below demonstrates the various bailout programs (and key bailout players) sorted chronologically.
The dangerous thing here is that as time has evolved and the crisis has deepened, the Fed has become willing to accept much less sound assets as collateral, initially the default being safe US Treasuries (although with US Debt/GDP likely to skyrocket past 100% over the next several years, even this category can be perceived as risky), however the bar has subsequently dropped lower and lower to include first tier commercial paper, investment grade debt, and at the bottom of the rung: a full range of discount window collateral which includes, among others, residential and commercial real estate loans, CMOs, and corporate bonds.


Does this telegraph that the Fed, in loosening its high quality collateral standards, is anticipating expanding the bailout programs to a point where it is willing to accept not only HY bonds as collateral but outright equities? The last preposition is frightening, especially if there is any direct or indirect method that the Fed or the Treasury possess in order to manipulate equity price levels, as this would effectively translate into the biggest conflict of interest in history. But even assuming that conspiracy theories are too far-fetched for the purpose of this rational discourse, the declining collateral quality trend is very troubling. If eventually the system reaches a point where taxpayer money is collateralized by the investments (speculations) that these very same taxpayers (for the most part) invest in equities and other market securities, the circular logic of bidding up assets in order to prevent collateral quality from falling (and thus wiping out taxpayers) will become the de facto norm. In a way, this puts yet another twist in the ongoing bifurcation between U.S. taxpayers and U.S. investors who very often are the very same individuals.The conclusion is that if one did not fear the “full faith” retaliation of the U.S. government, one would be tempted to define Kohn’s statement as not only groundless cheerleading, but ultimately predatory disinformation dissemination. However, as we here at Zero Hedge observe our daily fear of the abovementioned phenomena, we would not go so far as to make that broad an assumption. Instead we will leave this topic as an open question, welcoming reader feedback, and hope to have provided sufficient food for thought as the U.S. economy deteriorates more and more from the consequences of the biggest credit unwind in the past 70 years.***One additional point with regard to reader feedback: commenting at Zero Hedge is meant to be an open forum for information exchange and discussions. However, an alarming trend is the observation of trolling by certain commentators, who abuse the above principle for the sake of populating comment threads with no meaningful benefit to anyone, and outright character attacks at times. This behavior will not be tolerated and individual IP addresses as well as entire domains will be banned from commenting without prejudice going forward. This is a first and last warning.

Originally published at the Zero Hedge blog and reproduced here with the author’s permission.

6 Responses to "The Evaporating Collateral Of The United States"

  1. Guest   April 19, 2009 at 12:37 pm

    When we hit 50% unemployment, we’ll have a revolution. That’s what we’re waiting for. Don’t expect anything but more corruption, until then. Why even bother writing columns like these.Read my book instead, The Eminent Domain Revolt. Why? Because what’s happening is that the scrutiny regime of West Coast Hotel v. Parrish (1937) is collapsing and the maintenance regime, which I describe in the book, is coming into power.How many dead bodies between the scrutiny regime and the maintenance regime? Who the hell knows?Cheers,John Ryskamp

  2. Guest   April 20, 2009 at 9:25 pm

    “SPAM is not welcome here, I hope this post is removed and your IP blocked, permanently. GO AWAY. I’m sick of websites being ruined by this sort of abuse”The same could be saif of Mr Ryskamp’s response, no?

  3. paul94611   April 20, 2009 at 11:33 pm

    The credit quality of the collateral the fed has been accepting has been at question for some time. Hence the reasoning behind the fed’s refusal to disclose this information. The fed and the treasury will abuse this capacity until it collapses upon itself or the miraculous recovery materializes. The inability of the government (yes, the fed is included) to shoot straight with those that are governed and ultimately financially liable for their decisions may well be the catalyst for the complete breakdown in governing authority.

  4. Gerry   April 24, 2009 at 3:33 am

    I’m not trained in economics, but have a post-graduate education in the social sciences. It seems to me that the entire rescue program is bound to fail for the following reason: A meta assumption of the “We’ll spend our way out of this” team appears to be that consumer demand will not only take on the same pattern of consumer goods desired prior to the crash, but will also reach the same volumes, and then continue to grow some. Pre-crash manufacturing capacity assumes such a rapid rate of consumerism will return. But, the loss of personal wealth is wide-spread and huge, (without even taking into account the distribution of loss for the minority wealthy to tax-payers, through the various rescue packages) and consequently the spirit of the age has turned. “We the People” don’t need to buy new computers, cars, plastic rubbish bins etc at the rate at which they were being bought. And that’s where the massive rescue plans just plan comes unstuck …. or does it?I hope someone with far more insight, and clarity of expression can post a response that will point out follies in my thinking. I look forward to sleeping better at night.RegardsGerry