Thursday, September 18, 2008

Federal Agency Loan Sharks

The United States Treasury recenty took 79.9% of Freddie Mac (FRE) and Fannie Mae (FNM) in exchange for $1 Billion investments in the form of 10% senior preferred (12% if not current in cash) and an undisclosed quarterly management fee (and the right to invest more at the same rate, and the right to overrule other fundraising, and -- hah, lest I forget -- complete dominion over the companies).  Then, the Federal Reserve made a double-digit-interest secured line of credit available to AIG in exchange for 79.9% of its business.  The Federal Reserve Bank isn't the same as the Treasury, but it sure soulds like they are both getting the same kind of advice on how to structure deals.  One stock-board poster suggests the government is taking a page from the book of a venerated financial institution:  Italian crime family protection rackets.

In the face of recent money market fund failures, the Treasury can now raise short-term money at rates that offer negative post-inflation returns.  The absolute rate of interest paid to holders of two-year Treasury bonds is currently less than two percent. In these frightening times, some investors have been willing to accept a negative return on Treasury debt -- literally paying the government to hold the money.  Getting paid to safekeep money is an easy business for the government that prints the cash.  To the extent government agencies can get credit at a cost so much less than can be obtained from investments, there's a theoretical opportunity for the government to make money on the spread.

Like the Federal Housing Finance Authority, the Federal Reserve Board is a federal agency.  The Federal Reserve Bank issues shares to member banks, but those shares don't entitle member banks to control, or even capital appreciation.  Member banks' shares don't convey normal shares' right in the equity of the entity, but only a statutory right to 6% interest on the funds paid in for the shares.  It's balance sheet isn't part of the federal government's books, but its Board is nominated by the President of the United States much as are senior Cabinet members.  A term on the Federal Reserve Board is fourteen years (though one may not serve two terms), ensuring continuity across several administrations.  The Board is considered a federal agency, but the Bank has separate books.  Profit at the Bank doesn't flow to the books Congress has been failing to balance for decades, and it doesn't flow to member banks.  The Fed offers an overviewhere.  

What exactly is the incentive at the Federal Reserve Bank?  Why would the Federal Reserve want to loan money to AIG?

The idea at the Federal Reserve Bank is to allow knowledgeable professionals (Board members are drawn from member banks, and the various advisory panels have backgrounds specified in by the government) to work out how to keep the banking environment good for stable banking business, without tainting anyone's view about the right mechanism by creating a profit motive within the Federal Reserve Bank itself.  On the other hand, the Federal Reserve's interest in stability is raised by the threat AIG offers:  its trillion dollars in assets are apparently matched by a book of liabilities about the same scale --  estimates of breakup value for AIG are on the order of $150 Billion.  This means that most of a trillion dollars in liabilities are owed to firms all over the globe, many of them capable of impacting the business of Federal Reserve member banks.  If the Federal Reserve could take control of AIG by offering a bridge loan, it could steer the future course of AIG's business toward financial stability rather than toward boosting short-term numbers to meet quarterly bonus thresholds.

The Federal Reserve Bank's deal with AIG isn't a handout;  it's a double-digit loan under a facility with a lifespan of two years.  The loans may not need to reach the $85 Billion limit, but the fact this liquidity is available means AIG can make an orderly exit from positions and extract good value from its salable assets instead of being forced to dump them on fire-sale terms to creditors to whom it is a defaulted counterparty.  The ability to keep AIG out of bankrutcy, and to maintain confidence in the company so it can continue operations, may be worth the 80% stake the Fed gets.  I'm not sure how taxpayers benefit from a flush Fed -- it doesn't reduce the deficit, for example -- but there has to be an angle here.  After all, the bailout is being conducted with money raised by the Treasury.

With government agencies stepping in with a lifeline for financial behemoths in exchange for 80% stakes and double-digit interest rates, I'm interested to hear the government's thinking on its new activism in the marketplace.  Are we headed back to an era of municipal trading?  Will government start trying to make a financial return on its investments?  Is this a fluke?

I'm dying of curiosity.  Particularly in light of the possibility that these institutions might be righted and set on a profitable course, I'm interested to understand how the government will utilize its 79.9% controlling stakes in these entities, and on whose books profits should show up if they materialize.

Given that government stands to get paid to hold money for fearful investors, the possiblity that government might pursue profitable deals and could keep the spread between its loan costs and its financial return is a fascinating prospect.  Unfortunately, since Congress can't balance its checkbook this has no hope of actually resulting in sound government finances.

Maybe Congressional pay should be linked to debt reduction targets.  Someone has to impose discipline on those children.

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