Why the Fed Bailed Out the iBanks

This is the best explanation I have seen as to why the Fed set up the TSLF, and allowed it to accept less than stellar paper:

"The real problem began in late February, as several of Wall Street’s
biggest investment banks prepared to close their books for the quarter
and realized they were looking not only at big declines in profit from
issuance of new stocks and bonds and fees from mergers and
acquisitions, but also another round of write-offs in the value of
their holdings. In response, the banks began to hunker down,
instructing their trading desks to raise margin requirements for hedge
funds and other customers, requiring them, in effect, to post more
collateral on their heavy borrowings.

Thus began a chain reaction
in which hedge funds began selling what they could — largely
mortgage-backed securities guaranteed by Fannie Mae, Freddie Mac
and Ginnie Mae — to raise the cash to meet their new margin calls.
That wave of forced selling drove down the price of those bonds, which
prompted more margin calls and more forced selling. By the end of last
week, the interest rate spread on those securities — the difference
between their yield and that of risk-free U.S. Treasury bonds — had
jumped four, five, even 10 times the normal rate.

Among those caught up in the vicious cycle were hedge funds run by such blue-chip names as KKR and Carlyle Group, along with Thornburg Mortgage, a big mortgage lender. News of their troubles swept through Wall Street, heightening the sense of panic, as did rumors that Goldman Sachs was about to post big losses and Bear Stearns was about to run out of cash. Meanwhile, Lehman Brothers
announced that it would lay off 5 percent of its staff in what was
viewed by many as a first installment of a consolidation that would
eventually eliminate 20 percent of the jobs on Wall Street. Analysts
began to warn that financial-sector losses from mortgages, commercial
real estate, failed takeover loans and other bad gets could reach as
high as $1 trillion.

It was against this backdrop that the Fed
announced Friday that it would auction $200 billion in additional loans
to banks looking for cash to lend or use as reserve capital. By
accepting AAA-rated mortgage-backed securities as collateral for the
loans, the Fed aimed to restore confidence and trading in that
beleaguered market and begin to put a floor under prices."

Read the entire article — but the above explains the gravamen of the Fed’s actions . . .


A Bailout. For Everyone
Steven Pearlstein
Wednesday, March 12, 2008; Page D01

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