Dear Mr. Buffett_ What an Investor Learns 1,269 Miles From Wall Street - Janet M. Tavakoli [83]
On March 11, 2008, Bloomberg News issued its article suggesting the rating agencies propped up AAA rated subprime residential home equity loan-backed bonds backing the ABX index. According to its analysis of S&P data, none of the assets backing the index merited an AAA rating and it took only a short step for readers to realize that 90 percent of the bonds in the AAA index were not even investment grade.24 “Peloton,” I told an investment banker, “was leveraged and long an ABX index, so the news suggests the depressed prices may not rebound and investment banks will take losses on those positions. Carlyle’s CCC is long AAA agency assets, and it cannot meet its margin calls. No wonder they want the Carlyle Group to put up more collateral (margin).”
The Carlyle Group was not alone. Anyone who was long would have to put up more collateral. Was John Paulson correct the previous summer when he hypothesized that, when Bear Stearns appealed to ISDA, it was trying to avoid making billions of dollars in payments on credit default swaps?25 If so, the Bloomberg article was devastating news. At a minimum, Bear Stearns would have to come up with more collateral to back those trades and it might eventually have to make payments to cover defaults.
The Federal Reserve Bank took unprecedented action that had the effect of being an indirect bailout for the Carlyle Group. It created a new Term Securities Lending Facility (TSLF). Instead of lending overnight it extended the term to 28 days to primary dealers and would accept “federal agency debt, federal agency residential mortgage-backed securities, and nonagency AAA and Aaa rated private label residential MBS.” The program would start through weekly auctions beginning March 27, 2008, and the Fed would lend up to $200 billion of Treasury securities in exchange for the collateral.26 How soon can you stuff overrated AAA assets to the Fed so you don’t have to show a loss on your balance sheet?
Traditionally, the Fed freely provides liquidity to the U.S. banking system’s securities arms including: Banc of America Securities LLC, HSBC Securities (USA) Inc., and J. P. Morgan Securities Inc. But the Fed had never before opened securities lending to all primary dealers including some foreign banks, U.S. brokers and investment banks: BNP Paribas Securities Corp, Barclays Capital Inc. Bear, Stearns & Co., Inc., Cantor Fitzgerald & Co., Countrywide Securities Corporation, Credit Suisse Securities (USA) LLC, Daiwa Securities America Inc., Deutsche Bank Securities Inc. Dresdner Kleinwort Wasserstein Securities LLC., Goldman, Sachs & Co., Greenwich Capital Markets, Inc., Lehman Brothers Inc., Merrill Lynch Government Securities Inc., Mizuho Securities USA Inc., Morgan Stanley & Co. Incorporated, and UBS Securities LLC. Although the program would not begin until March 27 for primary dealers, banks should now be more willing to provide back-door financing for them in the meantime.
The Fed was supposed to protect banks not nonbank investment banks and nonbank primary dealers. Primary dealers included the worst actors in the subprime lending crisis. The Fed not only failed to speak out against the bad guys before or during the crisis, it had just announced it was bailing out some bad guys after-the-fact.
Similar to the terms of its August 2007 bailout of Countrywide’s borrowing problems, the Fed would lend up to 28 days. The primary dealers had to pledge securities to secure the loans. The Fed announced it would accept mortgage-related assets having AAA ratings as well as other assets with any kind of nominal investment grade rating. The Fed proposed to “haircut,” or discount those securities by 5 percent, but that would not be nearly enough to cover potential losses. The only condition was that the assets could not be on negative credit watch. Given how poorly the ratings