In Walther Bagehot’s famous formulation, central banks should lend during crisis situations “against good collateral at penalty rates.” Apparently, during the maelstrom of the crisis in September, 2008, the Fed considered pretty much anything “good collateral,” except perhaps Lloyd Blankfein’s baseball card collection and a ‘72 Buick up on blocks in front of an old doublewide somewhere in Alabama. As revealed in documents pried out of the Fed as result of a FOIA request, the US central bank lent massive amounts against very dodgy collateral:
At the height of the financial crisis, the Federal Reserve allowed the world’s largest banks to turn more than $118 billion in junk bonds, defaulted debt, securities of unknown ratings and stocks into cash.
Collateral of those asset types made up 72 percent of the total $164.3 billion in market-rate securities pledged to the Fed on Sept. 29, 2008, two weeks after the bankruptcy of Lehman Brothers Holdings Inc., according to documents released yesterday. The collateral backed $155.7 billion in loans on the largest day of borrowing from the Primary Dealer Credit Facility, which was created in March 2008 to provide loans to brokers as Bear Stearns Cos. collapsed.
. . . .
The Fed loans on Sept. 29, 2008, represented a 5.49 percent “collateral cushion,” the amount by which the pledged assets exceeded the loan value, according to the Fed data. Equities comprised $71.7 billion, or 43.6 percent of the total. High- yield debt, including the defaulted issues, accounted for $18.4 billion, or 11.2 percent. Collateral of unknown rating was $28 billion, or 17 percent.
High-yield, high-risk bonds are rated below Baa3 by Moody’s Investors Service and lower than BBB- by Standard & Poor’s.
The haircut–the percentage by which the collateral value exceeded the amount of money lent–was amazingly small, given the quality (or lack thereof) of the collateral, and prevailing market conditions. The 5.5 percent haircut was far smaller than the 40 percent number that was prevalent during these days (as estimated by Gary Gorton). Moreover, it was a pitifully small number for the equity that made up the largest single component of the collateral accepted by the Fed. On the 29th, the VIX equity volatility index closed at a record of 46.72. Thus, there was a very high likelihood of an adverse price move that would have put the equity collateral under water.
It’s also an open question of whether the marks on the collateral reflected true market values. I pretty much doubt it. It’s not outside of the realm of possibility that the real haircut was negative.
Note too that very few Treasuries were posted as collateral: presumably all this was out on repo, and the desperate need for liquidity forced banks to pawn everything else in the safe at Uncle Ben’s Cash America.
These eye opening data reveal just how extreme the situation was post-Lehman. Or at least how extreme the Fed considered the situation to be. Given those extraordinary circumstances, it is understandable why the Fed acted in a truly extraordinary way, and honored Bagehot more in the breach than the observance.
The real issue that still remains unresolved is how this in extremis situation came to be. Did the Fed’s and Treasury’s handling of Lehman, and before that Bear, create the panic? The Fed’s version of Pawn Stars on steroids is but a symptom of what had transpired in the days, months, and years leading up to 29 September. That’s what we need to understand better–far better–than we do now.