Recently, the Federal Reserve gave everyone a peek inside the bag. Specifically, they disclosed the contents of much of the Maiden Lane off-balance sheet entities they created to absorb some of the toxic debt and provide financing (read bailout) for propping of AIG and also JPMorganChase’s buyout of Bear Stearns among other things.

The following Bloomberg article reveals:

In a 4:30 p.m. announcement in a week of congressional recess and religious holidays, the central bank released details of securities bought to aid Bear Stearns’s takeover by JPMorgan Chase & Co. Bloomberg News sued the Fed for that information.
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“The Fed absorbed that risk on its balance sheet and is now seen to be holding problematic, legacy assets,” said Vincent Reinhart, a resident scholar at the American Enterprise Institute in Washington who was the central bank’s monetary- affairs director from 2001 to 2007. “There is both an impairment to its balance sheet and its reputation.”

The Bear Stearns deal marked a turning point in the financial crisis for the Fed. By putting taxpayers at risk in financing the rescue, the central bank was engaging in fiscal policy, normally the domain of Congress and the U.S. Treasury, said Marvin Goodfriend, a former Richmond Fed policy adviser who is now an economist at Carnegie Mellon University in Pittsburgh.

‘Panic’ Cause

“Lack of clarity on the boundary between responsibilities of the Fed and of the Congress as much as anything else created panic in the fall of 2008,” Goodfriend said. “That created a situation in which what had been a serious recession became something near a Great Depression.”

Central bankers also created moral hazard, or a perception for investors that any financial firm bigger than Bear Stearns wouldn’t be allowed to fail, said David Kotok, chief investment officer at Cumberland Advisors Inc. in Vineland, New Jersey.
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Assets in Maiden Lane II totaled $34.8 billion, according to the Fed, which set their current market value in its weekly balance sheet at $15.3 billion. That means Maiden Lane II assets are worth 44 cents on the dollar, or 44 percent of their face value, according to the Fed.

Maiden Lane III, which has $56 billion of assets at face value, is worth $22.1 billion, or 39 cents on the dollar, according to the Fed’s weekly balance sheet. A similar calculation for the Bear Stearns portfolio couldn’t be made because of outstanding derivatives trades.

Bloomberg had sued the Fed under FOIA request to get a look at what was in these entities. After losing at least two court rulings, the Fed finally gave disclosure.

It’s not pretty.

The controversy at the time of creating these entities is indicated by the bolded part above. Namely, that the Fed was directly engaged in fiscal policy, exposing taxpayers to bailouts without the consent of Congress as clearly defined in Article 1 Section 8 of the US Constitution. This is commonly spoken as “All government spending must begin as a bill in the House of Representatives”. A pretty clear violation of law.

Indeed, Paul Volcker, the former Chairman of the Federal Reserve criticized the Bear Stearns deal as being at “the very edge of legality”. A pretty strong characterization coming from an insider.

There are rumors now that the Fed itself is in trouble with its balance sheet now that it holds these toxic securities and is disclosing how badly they are performing. There is talk of actively targeting the Fed to take advantage of its seemingly precarious position.

Last year there we discussions of forming a ‘Bad Bank’ to pile all the toxic debt into. It now appears that perhaps the Federal Reserve is the ‘Bad Bank’.

Does this presage the Fed’s demise? My visceral reaction is that although the potential asset deterioration in its portfolio is enough to impair the capital of the Fed, the central bank is not without considerable resources at its disposal to strengthen its capital position.

• You must remember that the Fed is privy to considerable amounts of non-public (i.e. insider) information and it routinely trades on this information to its advantage. Legally, by the way. The Federal Reserve has an exemption that permits it to do this.
• There was talk during the September – November 2008 credit crisis period of the Fed selling its own bonds to provide itself financing. This talk could come back.
• The Fed has a large portfolio of Mortgage Backed securities it is holding to offset the excess reserves on deposit at the Fed. If things get dicey for them because they come under speculative attack, they can fire back at the speculators by dumping these securities back on the market and pulling a trillion or more dollars of liquidity out of the system. This action would drive the dollar higher, Treasury yields lower, and consequently its own portfolio of Treasuries would rise in value.

There could of course be other actions they could take. I’d have to think on that a bit.