Nationalizing Risk, Privatizing Profit

May 26, 2008 – A logical deduction about the long term plan of the Federal Reserve with regard to the “toxic” securities it’s accepting as collateral in exchange for loans to banks.

By The Cerebral Aesthetic Vagabond

For months, ever since the systemic financial crisis became evident to all, the Federal Reserve has been “lending” money to other banks, accepting as collateral all manner of “toxic” securities that many have appraised as worthless. While many writers have decried on principle the tens or hundreds of billions of dollars being lent, I have yet to read a single query about the eventual disposition of these “loans” and the associated collateral. It seems as if everybody just accepts at face value that these loans will be repaid once the financial crisis blows over (I don’t think it’s going to blow over, but that’s another topic).

Simple logical deduction, however, suggests that these loans will never be paid back and that these toxic, worthless securities will ultimately disappear into some governmental black hole, saddling the taxpayers with a significantly higher national debt.

From The Borrowers’ Perspective

The banks that are borrowing from the Federal Reserve are most likely doing so out of necessity; some of them are probably close to being insolvent. It would seem, therefore, that demanding that these borrowers repay the loans would return them to the brink of insolvency, if they even have the means to repay the loans when the time comes.

Additionally, these banks jumped at the opportunity to unload these worthless securities on somebody else. Why would they willingly buy them back if they are worthless? In all likelihood, the securities will be worth even less in the future, making the prospect of buying them back even less attractive to the borrowers. For example, the biggest problem in the housing market right now is that the collateral is worth less than the loans. Among other consequences, the upside down nature of house values to mortgages is causing people to simply walk away from their mortgages, in other words, to relinquish the collateral instead of paying back the loans. Will banks behave any differently with respect to the loans they obtained from the Federal Reserve? Would they not simply default on the loans and let the Federal Reserve keep the worthless collateral?

So I don’t see a scenario in which the banks that borrowed from the Federal Reserve will have either the means or the willingness to pay back those loans in the future.

From The Federal Reserve’s Perspective

The Federal Reserve is a private, for-profit entity. It stepped into the fray of the financial crisis, becoming the lender of last resort because nobody else was willing to do it. The banks don’t trust one another and so they won’t lend to one another. Nor are the banks willing to purchase or accept as collateral these worthless securities. So why, if the Federal Reserve is a for-profit bank, is it willing to do what other for-profit banks are not? It’s certainly not lending this money out of the goodness of its heart. And it’s certainly not going to make a profit on these loans. So why would it make these loans?

Deduction

Superficially, the Federal Reserve’s actions make no sense, so I suspect that it has a plan:

  1. Convert these loans into sales at some opportune future time.
  2. Sell the collateral thus purchased to somebody else.

There is only one potential buyer with the funds and willingness to purchase these worthless securities: the United States Government.

Although the Federal Reserve is a private company, it has a close relationship with the United States Treasury, a government agency. I suspect that the Federal Reserve will ultimately sell these worthless securities to the U.S. Treasury. The national debt will balloon (what’s another couple of trillion dollars when the national debt is already nine trillion dollars?) and the worthless securities will disappear into some governmental black hole, never to be seen again.

The nation’s banks and the Federal Reserve will be made whole again, and the public will unwittingly assume responsibility for the banks’ losses.

The End