I have been reading the lively discussion of several diaries today about the bailouts and TARP, and the question of whether they were profitable to the taxpayer. I'll leave that discussion for those threads. Here I want to address one small aspect of the debate which comes up over and over -- namely, that no matter how profitable TARP may end up being, it does not take account of the "fact" that the big banks were able to borrow from the Fed at zero percent, and then buy Treasuries that paid a positive interest rate, and make money on the spread.
This comes up pretty much every single time anyone tries to do a cost accounting of the various bailouts.
While it may feel righteous to have discovered the "secret" of how banks made money in the wake of the financial crisis and bailout, this is just one more myth about what happened. It's a myth based on bad reporting, which in turn is rooted in the fact that most reporters, even business and finance reporters, have only the dimmest grasp of the world they are reporting on.
I'm not sure where this idea came from, but the following article in Huffington Post is pretty typical:
http://www.huffingtonpost.com/...
Money For Nothing: Wall Street Borrowed From Fed At 0.0078 Percent
Shahien Nasiripour
NEW YORK -- For the lucky few on Wall Street, the Federal Reserve sure was sweet.
Nine firms -- five of them foreign -- were able to borrow between $5.2 billion and $6.2 billion in U.S. government securities, which effectively act like cash on Wall Street, for four-week intervals while paying one-time fees that amounted to the minuscule rate of 0.0078 percent.
That is not a typo.
On 33 separate transactions, the lucky nine were able to borrow billions as part of a crisis-era Fed program that lent the securities, known as Treasuries, for 28-day chunks to the now-18 firms known as primary dealers that are empowered to trade with the Federal Reserve Bank of New York. The program, called the Term Securities Lending Facility, ensured that the firms had cash on hand to lend, invest and trade.
...
On each transaction, the fee paid for the 28-day loan is equal to a rate of just 0.0078 percent.
Notice that the Fed wasn't lending the big banks "cash"; it was lending them Treasuries, that is the federal government's own debt securities, which we know pay interest. The "reporter" suggests that no interest other than this fee was paid, which meant that the banks were borrowing at .0078% and buying Treasuries that yielded 3%, and therefore, it would seem like the banks were getting free money in the form of interest on Treasuries in the amount of 3% minus .0078% or roughly 2.99%.
Even worse, according to this explanation, which has now hardened into the "irrefutable" certainty of urban legend, the Fed accepted "toxic trash," in the form of mortgage backed securities, as collateral for these loans of Treasuries.
The reason this program was set up is that banks hold billions of dollars of mortgage backed securities. They are the bread and butter of banking. Banks pledge them to each other for overnight loans and other inter-bank transactions. At the time, and throughout 2008, as foreclosures grew to alarming rates, banks began being afraid to take mortgage backed securities from each other as collateral, and the entire banking system began to freeze up, to the point that the system of settlements (whereby banks accept checks for deposit and ATM transactions drawn on other banks) was freezing up. So the idea was that the Fed would allow banks temporarily (28 days, but renewable) to replace their unusable mortgage backed securities with Treasuries, which all other banks would accept.
Sounds terrible right? That sneaky, underhanded Bernanke was giving away money to the banksters!!! Right? Right?
Actually, wrong.
The tip off that there is something wrong in the reporting is that the "reporter" describes this .0078% as interest, but his source obviously describes it as a "fee." In banking, when a bank lends a corporation money, for example, it will set an interest rate (say, 5%), but also charge "fees." The fees are really to cover administrative costs, like hiring lawyers to negotiate the banking agreement. While the corporate borrower may calculate his total interest costs by aggregating in the fees, the fee is not itself interest. It's what it is -- a fee.
By the way, the reporter didn't even get the calculation correct, as several commenters immediately pointed out in response to the article.
So the question is, if this .0078 percent is a fee the Fed charged the big banks, what was the interest the Fed charged the banks?
The answer is simple: it was the interest on the collateral, that is, on the mortgage backed securities.
And these securities were not toxic -- there was just a panic making even gold plated securities too scary to touch. The only securities that the Fed would accept were these gold plated securities that other banks were afraid to accept and much of it was Triple A rated MBS issued by Fannie and Freddie, which many economists and financial reporters were predicting, the federal government was about to nationalize. As Paul Krugman explained it:
http://krugman.blogs.nytimes.com/...
Paul Krugman
March 11, 2008, 9:28 am
Sterilized intervention, big time
The Fed is making its sterilized intervention — monetary policy on the asset side of its balance sheet — even bigger. Now there’s the Term Securities Lending Facility — would that be pronounced "tiss-lif"? — which, according to the Fed,
will lend up to $200 billion of Treasury securities to primary dealers secured for a term of 28 days (rather than overnight, as in the existing program) by a pledge of other securities, including federal agency debt, federal agency residential-mortgage-backed securities (MBS), and non-agency AAA/Aaa-rated private-label residential MBS.
About those AAA-rated private-label MBS, Bloomberg reports:
Even after downgrading almost 10,000 subprime-mortgage bonds, Standard & Poor’s and Moody’s Investors Service haven’t cut the ones that matter most: AAA securities that are the mainstays of bank and insurance company investments.
...
{the following is Krugman again:}
So basically the Fed is going to be swapping Treasuries for dubious securities, in an attempt to give the market a REALLY BIG slap in the face. I understand what they’re doing, and might have done the same in their place. Still, all I can say is Wheeeee!
So here is the absolutely huge error Shahien Nasiripour made in reporting this story.
He presented it as the Fed lending Treasury securities that paid 3% to banks while only charging .0078% interest, while accepting toxic mortgage securities.
In fact, what was happening was that the Fed and the banks were swapping Treasuries for AAA rated mortgage securities.
Because it was a swap of securities, the Fed got to keep the interest paid on the mortgage securities.
The interest rate on the mortgage securities is always higher than the interest on the Treasuries. At the time, gold plated mortgage securities were yielding about .25% higher than Treasuries.
Therefore, the "reporter" got the story exactly backwards. It was the Fed that was making money on the spread, not the banks. The banks were losing money on the swap. Of course, they had no choice. To paraphrase Michael Corleone, Bernanke was making them an offer they couldn't refuse, considering that banks that couldn't make settlement were falling like dominoes.
Moreover, the Fed required the banks to "take a haircut." That means that if the banks wanted to swap, say $1 billion in mortgage securities for Treasuries, the Fed gave them a 10% haircut, providing only $900 million in Treasuries for $1 billion in mortgage securities, boosting the spread or float that the Fed earned from the banks. As a former Fed official explained it at the time:
http://economistsview.typepad.com/...
Former member of the Federal Reserve staff member Douglas Elmendorf adds:
Taking agency MBS as collateral does not meaningfully increase the risk faced by the federal government. First, the Fed will presumably require a significant "haircut" on the value of the collateral. Second, if the federal government would ultimately prevent a default by Fannie and Freddie anyway, absorbing some of that commitment now does not add to the overall risk. Taking private MBS as collateral does increase risk, unless an adequate haircut is taken, because the government is otherwise unlikely to stand behind the truly private lenders.
Also, the banks were allowed to use these Treasuries as collateral for loans from other banks in order to free up inter-bank lending and settlements, not to just engage in speculative behavior or pay out bonuses.
Once again, we see Ben Bernanke wasn't giving away the store. He was acting like a sharp pawn broker, willing to take risks on the banks' assets in order to stabilize the system but requiring them to pay for it.
Make no mistake. This was an extremely risky move on Bernanke's part. He basically assumed that the rest of the Federal government would not allow Fannie and Freddie to fail to deliver their guarantees on their mortgage backed securities, which of course, turned out to be correct.
But the terms he imposed is the reason the Fed made money on the deal, and deposited tens of billions of dollars in the US treasury as a result of this and the Fed's other emergency measures.
But can we now retire the myth that the Fed gave the banks free money that allowed them to purchase Treasuries and earn money on the spread?
UPDATE/Correction -- Sorry, in one paragraph, I suggested that Fannie and Freddie were already nationalized. They weren't when the program started.