The Federal Reserve and Junk-Bonds

Ludwig von Mises once wrote: “Economics, as a branch of the more general theory of human action, deals with all human action, i.e., with man’s purposive aiming at the attainment of ends chosen, whatever these ends may be.”

Essentially, market participants act in their self-interest. For this reason, I find it hard to believe that the Federal Reserve actually thought the assets it purchased and stored in Maiden Lane would remain investment-grade. After all, if the assets were so valuable, JPMorgan Chase and Co. (JPM) would have kept them for themselves. The fact that JPM was not interested in the assets should have sent a clear message to the Federal Reserve that the assets were not worthwhile.

Instead, as this Bloomberg article points out, the “Fed Made Taxpayers Unwitting Junk-Bonds.” According to Bloomberg, “more than 88 percent of Maiden Lane’s CDO [collateralized debt obligation] bonds and 78 percent of its non-agency residential mortgage-backed debt are now speculative grade… as of Jan. 29.”

The classification, speculative grade, refers to a rating of BB or less. With respect to bond ratings, a rating of BB or below corresponds to “low credit-quality (non-investment grade), or ‘junk bonds’ [as well as] bonds in default for non-payment of principal and/or interest.”

One requirement concerning the resultant offloading of assets by JPM onto the Federal Reserve was that the assets purchased had to be at least investment-grade (i.e., rated above BB). But, in Bernanke’s own words on January 10, 2008: “The complexity of structured credit products, as well as the difficulty of determining the values of some of the underlying assets, led many investors to rely heavily on the evaluations of these products by credit-rating agencies … However, as subprime-mortgage losses rose to levels that threatened even highly rated tranches, investors began to question the reliability of the credit ratings and became increasingly unwilling to hold these products.” Then, a few months later, Bernanke conveniently forgot what he had said and continued the transaction anyways. To be fair, an independent evaluation was performed on the assets, but I highly doubt it was sincere.

Most importantly, “Bernanke and Geithner didn’t detail during the hearing that the Fed would expose itself to below-investment-grade assets through credit derivatives it was also acquiring. The $16 billion of credit-default swaps included bets protecting some junk-rated asset-backed securities against default … because the terms weren’t made public.”

Perhaps the most preposterous aspect of the whole fiasco is the insistence by the Treasury that the taxpayer will not lose a dime on the government’s loan. The Congressional Budget Office (CBO) estimates the Fed’s profit will be $200m by 2020.

Imagine that! Maiden Lane, which has a total of over $163b in assets (as of March 31, 2010), will yield a profit of $200m by 2020. The profit, in terms of percent with respect to the initial investment size, is expected to be 0.123%.

Clearly, the Federal Reserve does not have the taxpayers best interest at heart. Unfortunately for now, the true version of the Audit the Fed bill is dead. I hope we can succeed in having it passed next year.

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