Thursday, March 13, 2008

Shadow Banking System Redux?

In some ways I can see the reasoning behind the Fed’s action to accept mortgage backed paper as collateral, as “end of the tail” / outlier times call for creative thinking. Ater reading 2 bloomberg articles though I couldn’t help but hope were not opening the door to the recreation of the shadow banking system, this time though housed at the Federal reserve;

“The Federal Reserve, struggling to contain a crisis of confidence in credit markets, will for the first time lend Treasuries in exchange for debt that includes mortgage-backed securities.”

So, since the first mortgage backed security innocently appeared in 1970, we traversed thru……. numerous recessions, 1970’s stagflation with double digit inflation / unemployment, various periods of credit market difficulty such as massive banking failures via the S&L crisis, Michael Milken style junk bond bubbles, the late 90’s Asian crisis, country wide defaults ala Russia, etc……..yet the fed never felt it was a good idea to hold mortgage paper as collateral.

Don’t worry though, it’s only going to be the best stuff (from the same article)….

“Top-Rated Debt
The Fed said it will lend Treasuries for 28-day periods in return for debt including AAA-rated mortgage securities sold by Fannie Mae, Freddie Mac and by banks.”

So perhaps there is nothing to be concerned about. Hey some even say this AAA mortgage paper is undervalued. Then again, take a look at what’s passing for AAA these days via the 2nd Bloomberg article.

“None of the 80 AAA securities in ABX indexes that track subprime bonds meet the criteria S&P had even before it toughened ratings standards in February, according to data compiled by Bloomberg. A bond sold by Deutsche Bank AG in May 2006 is AAA at both companies even though 43 percent of the underlying mortgages are delinquent.”

Hopefully, at least privately the Fed is able to own up to falling asleep in not effectively regulating the shadow banking system, one which allowed questionable debt and liabilities to simply disappear through Enron-like SIV’s and also to be supposedly “hedged” via a maze of illiquid derivatives. Further, hopefully, the Fed fully realizes how tempting it must be for the banking system to effectively start back up at least the off-balance sheet SIV business, but this time in an even better scenario for them, under Federal Reserve stewardship.

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