shopyield.com

Comments from Jim Bianco, BiancoResearch, about the four major banks and their concentration of toxic assets… the instability in our financial system in contained mostly in these four banks… he argues that the Treasury and Federal Reserve have done a poor job in managing the crisis… these four banks need to be “ring fenced” and their counterparty exposure wound down and their debt holders must be “haircut”… this is commentary from the heart of the fixed income markets… bond market confidence in Treasury Secretary Geithner has sunk pretty low…

+   +   +

**** James A. Bianco is President of Bianco Research, L.L.C., an Arbor Research & Trading, Inc. affiliate. Since November 1990, he has been producing fixed income commentaries with a circulation of hundreds of portfolio managers and traders. Jim’s commentaries are primarily devoted to the fixed income markets with special emphasis on: money flow characteristics of primary dealers, mutual funds, hedge funds, futures traders, banks, and institutional investors. Other topics he has researched include: the effects of commodity prices on bond yields, how the ratio of the equity market’s capitalization as a percentage of nominal gross domestic product affects price performance of the stock market, the role government regulation plays in determining inflation, how market performance affects mutual fund investors, the role politics plays in setting interest rates, and measuring the stock and bond markets from a total-return perspective. ****

+   +   +

From the WSJ.com  (January 20th, 2009) ~~~~ “It has loads of subprime-mortgage bonds, souring commercial real-estate debt and collateralized debt obligations worth a fraction of their original value. This isn’t Citigroup Inc. or Merrill Lynch. It is the Federal Reserve.

In the past year, the Fed lent out more than $1 trillion in its efforts to stabilize the financial and credit markets. A chunk of that was used to buy mortgage-related securities and loans in the rescues of Bear Stearns Cos. and American International Group Inc., as well as other debt shunned by investors.

Now, the government’s recent aid packages for Bank of America and Citigroup have the Fed playing the additional role of a backstop guarantor for portfolios of about $400 billion in troubled assets that were dragging down those banks. Those assets include residential- and commercial-mortgage loans, mortgage securities, corporate leveraged loans and credit-derivative positions.

As the U.S. central bank, the Fed has a mission to maintain financial and economic stability and contain systemic risk in the markets. It lends only when the loans can be “secured to [its] satisfaction,” according to laws that govern the Fed’s activities.

But as the economy slows, mortgage and corporate defaults climb, and asset prices continue to decline, analysts are beginning to argue that U.S. taxpayers could end up shouldering losses from some of the Fed’s moves.

The Fed’s lending could swell by another $1 trillion or more in 2009 as its liquidity programs are tapped further by borrowers and it purchases more bonds, such as those issued by Fannie Mae and Freddie Mac, as well as securities backed by student loans, auto loans, credit-card receivables and small-business loans.

The result would be a Federal Reserve balance sheet at least three times its size 18 months ago, when most of the Fed’s assets were Treasury securities.

While the Fed has never had a loss before, notes James Bianco, president of Bianco Research in Chicago, its record may not mean much today.

“It’s a whole new ballgame for them. We’ve never seen anything like this in terms of the Fed broadening its reach before,” Mr. Bianco said. If the Fed incurs losses, “they run a real risk of hurting their credibility and running afoul of their collateralized loan rules,” he said. Losses also could undermine the Fed’s independence from congressional meddling.

In expanding its balance sheet and lending commitments, the Fed has relied on methods used by the very Wall Street institutions to which it has extended lifelines. The Fed uses credit ratings to help determine what to accept as collateral for its loans, employs structured-finance gambits to protect its positions and relies on imprecise valuation models to evaluate prices and monitor its exposures.

There is nothing inherently wrong with using each of these tools, but the recent financial crisis shone a light on many financial institutions and investors that relied too heavily on them and misjudged the risk.

A Fed spokesman said credit ratings help the Fed demarcate what securities fall within its “risk tolerance,” adding the central bank also can mitigate its risk of losses through “haircuts” on the collateral, or adjusting the amount it lends for each security pledged by borrowers.

Fed officials have said the central bank makes loans only where it expects to be fully repaid. Its loans are typically secured by collateral comprising the assets being financed. In some cases, other institutions have agreed to absorb initial losses from defaults among the assets.

The Fed’s program to lend up to $200 billion to purchase securities backed by consumer and small-business loans will be protected by a $20 billion contribution from the Treasury. That means losses from the securities would have to exceed $20 billion before the Fed’s loan is impaired.

Most analysts expect the Fed to recoup its money on its short-term lending programs, as most of the collateral it accepts is of relatively high quality. But they said the central bank bears significant risk on $75 billion in longer-term loans used to purchase troubled assets previously owned by, or linked to, Bear Stearns and AIG.

The Fed would be exposed to losses on the assets of Citigroup and Bank of America only after the banks themselves and other government entities have absorbed tens of billions in losses. But if that happens, the central bank’s exposure to risk could balloon. The Fed has committed to lend more than $200 billion to Citigroup and about $90 billion to Bank of America, though it is unlikely that much will be needed.

Some of the assets on the Fed’s balance sheet already have lost substantial value over the past six months. In the next several weeks, the Fed will provide an update on the value of assets in Maiden Lane LLC, a company it lent $29 billion last June to purchase $30 billion in assets formerly held by Bear Stearns. Those assets included securities backed by shaky Alt-A residential mortgages — a category of loans between prime and subprime — and commercial real-estate loans tied to companies, such as Hilton Hotels Corp., that are in slowing industries.

Maiden Lane was set up to facilitate last year’s rescue of Bear Stearns by J.P. Morgan Chase & Co., which provided $1 billion to the newly formed firm.

Last fall, the Fed said the value of Maiden Lane’s assets had declined to about $27 billion at the end of September. Analysts expect that value to have dropped further following a weak fourth quarter for the credit markets and declines in the values of many mortgage assets. Triple-A securities backed by commercial mortgages declined 11% during the quarter, while single-A securities lost 49%, according to Merrill Lynch indexes. Prices of Alt-A bonds, meanwhile, tanked late last year as loan defaults mounted.

Maiden Lane II LLC and Maiden Lane III LLC, created late last year to hold illiquid subprime-residential mortgage-backed securities previously owned by AIG, as well as collateralized debt obligations it insured, so far haven’t reported substantial write-downs that would impair the loans of roughly $43 billion the Fed has provided to the two companies.

Those securities were worth about half their original values at the time they were purchased by the two firms, and AIG agreed to absorb initial losses up to $6 billion. The fair value of the securities was recently $46.7 billion, according to Fed data. Their performance is largely tied to that of subprime borrowers.

“Ultimately, the risk is to taxpayers,” said Sung-Won Sohn, an economics professor at California State University, Channel Islands. “There’s no guarantee the Fed is going to get its money back, and it’s quite possible it could incur losses from the assets on its books, either from defaults or price depreciation, and Treasury or taxpayers would have to make up for them.”

Prof. Sohn said, however, that the Fed’s unprecedented moves are meant to prevent the economy from spiraling into a depression.

“The economic and social costs of that result would far outweigh the cost of buying all these assets,” he said.” ~~~~