By Yves Smith and Tom Adams, an attorney and former monoline executive
The Fed and its friends and enablers in power, most recently Rahm Emanuel, are fighting tooth and nail to beat back the Audit the Fed amendments to pending financial reform legislation.
That’s unfortunate and misguided. Even a cursory inspection of the Fed’s disclosures of its extraordinary rescue operations shows them to have been made only under duress, and then to be incomplete and deliberately unhelpful.
The reason this matters, is that, contrary to the Fed’s claims of independence, it has been operating as an extra-legal off balance sheet entity of the Treasury, circumventing normal Constitutionally-stipulated budget processes. And rather than make adjustments in its practices to reflect its enlarged and now overtly political role, the Fed has instead been engaging in cynical, blatant misrepresentation, giving lip service to the idea of greater transparency in public, while fighting disclosure tooth and nail.
Since the Fed has entered into an openly political stance (and this dates back to Greenspan) and cannot be relied upon to make truthful and complete disclosures, the only recourse is to put it on a much shorter leash, which includes greater scrutiny, including third party validation. The Fed has brought on the audit demands via the unabashed and repeated abuse of its privileged role.
The case study is its Maiden Lane disclosures. Readers may recall that the original Maiden Lane was a new entity formed to hold dodgy Bear Stearns assets, a backstop to induce JP Morgan to take the balance of the failed investment bank. JPM took a thin first loss position; the bulk of the capital came via a loan from the Fed, which means the Fed would lose money if losses exceeded the JP Morgan slice, which was a mere $1.15 billion out of $30 billion. Even though the backdoor subsidy to JP Morgan elicited a great deal of criticism, even from the normally taciturn Paul Volcker, the Fed was apparently so pleased with this idea that it used the same approach with AIG. The central bank created Maiden Lane II to hold dubious AIG mortgage assets, and Maiden Lane III for CDOs (alert readers may recall that Maiden Lane III was part of the mechanism that the New York Fed used to take various dealers that had credit default swap exposures to the Fed out at 100 cents on the dollar). All these vehicles are managed by BlackRock.
The Fed, aided and abetted by BlackRock, has long been publishing rosy valuations of the assets of the various Maiden Lane vehicles. Accuracy of valuation matters for a host of reasons. First, the public has a right to know how large the various government subsidies to the banking industry are, irrespective of Fed and Treasury efforts to camouflage them. Second, losses on the Fed’s accumulation of dreck may well rise to the level that it will require Treasury (meaning taxpayer) recapitalization of the Fed (the central bank can in theory “print” its way out of any shortfall, but as former central banker, now Citigroup chief economist Willem Buiter has pointed out, the Fed’s anti inflation mandate puts limits on how far it can go down that path). Third, this willingness to bend facts reveals troublingly cavalier attitude from a bank regulator. If the Fed thinks fudging its own marks is OK, it is likely to be unduly tolerant of truth-bending by the institutions it supervises.
Our own look at Maiden Lane III at the end of last year suggested the valuations were too high, but without more disclosure, we couldn’t reach any hard and fast conclusions. The Fed seems to be raising artful dodging to an art form, engaging in the form of disclosure when it fact is it simply providing impressive-looking data that is virtually useless from an analytical perspective.
Let’s look at a simple example. The Fed provided a juicy-looking list of the transactions in Maiden Lane, the Bear bailout vehicle. It would be nice to spot check some of the valuations, particularly since the portfolio was exposed to hotels (82.3% of the CMBS were “hospitality”). Hotels, unless they are in very prime locations, tend to be worth a lot less dead than alive. They are often built for particular hotel chains, and if that operator gets in trouble, the options for disposition of the asset are limited. The building may have no value to other users and has to be razed, leading to serious losses to lenders.
Now the Fed does report impaired assets for Maiden Lane, and it appears to mark them down aggressively (the year end report shows non-performing assets at 13.5% of par value) but it simultaneously appears to have gotten more liberal as to when it deems an asset to be non-performing:
In 2009 the LLC changed its classification of Non performing / Nonaccrual loans to include loans with payments past due greater than 90 days or when the LLC has doubts about the future performance of the loan assets. The prior year presentation disclosed all loans greater than 60 days past due. This change in presentation was made to conform with industry standards and did not have a material effect on the LLC’s consolidated financial statements.
Hhhm. It might be nice to see how Maiden Lane is carrying particular impaired assets. A recent Wall Street Journal story tells us a lot of hotels are in trouble right now. In particular, Red Roof Inns has had delinquencies since last June, plenty of time for it to be picked up in the 1/29/10 transaction level reports just released. But what do we see? Click to enlarge; see p. 21):
Now why is this significant? The values here foot with that of a prospectus on the “RRI Hotel Portfolio” prepared by Bear Stearns. From page d-14:
The Loan. The third largest loan (the “RRI Hotel Portfolio Loan”) is a $186,000,000 pari passu portion of a $465,000,000 first mortgage secured by the borrowers’ fee interests and leasehold interests in 79 Red Roof Inn hotels (the “RRI Hotel Portfolio Properties”)….
The Borrowers. The borrowers, R-Roof I LLC, R-Roof II LLC and R-Roof III LLC, each a Delaware limited liability company, are single purpose entities, each with an independent director, that own no material assets other than its respective properties in the RRI
Yves here. So what did the Fed give us? The stupid par value of the loans. We have no idea, nada, of the current carrying value. So there is no way for third parties to inspect the reasonableness of the marks. The reported non-performing commercial balance is well in excess ($1.1 billion) than the par value of the Red Roof loans. So there is more junk in there, but which deals? And are the values plausible?
The central bank’s Maiden Lane disclosure is a prime example of adhering to the form of disclosure while giving as little ground as possible on the substance. It’s a certainty that BlackRock’s reports to the Fed are more transparent and informative. We have pages of “HTL” entries with no balances (so if there are no assets, why are they listed?) and some isolated entries with amounts indicated, like the remarkably informative “HTL OWNED MEZZ I-II LLC” with a $22.932 million balance (p. 14).
But the real fun starts on p. 87 (of 131) with “Swaps and Hedges”. If mystery hotels were entertaining, imagine what a party mystery credit default swaps are. BlackRock can say these instruments are worth whatever it bloody pleases, and who in the chump public will be the wiser?
The Fed seems awfully keen to steer clear of the fate that befell Lehman. Lehman was grossly and verifiably misvaluing some investments, namely Archstone and SunCal, that confirmed doubts about the veracity of its accounting. If you can’t check any particular valuations, it’s a lot harder to ask difficult questions. And unlike Lehman, the Fed can continue to account to no one.
The Fed is engaging in same practices that caused the crisis: failure to make timely disclosures, obfuscation, use of off balance sheet vehicles to distance itself from losses. This posture alone should disqualify the central bank from assuming a greater regulatory role.
The Fed and Treasury’s three card monte operation is anti-democratic and possibly illegal, and to add insult to injury, voters are treated as if they have no right to know when they are ultimately footing the bill. The Fed’s persistent stonewalling and deep seated hostility toward the public provide ample proof of the need for an audit.