Paulson’s solution is to fill the derivative black hole with federal money; but as just noted, the funds aren’t likely to come from taxes or from loans from foreign central banks. The likely source is the Federal Reserve; and normally, the Fed gets its money just by printing it (or by creating it with accounting entries). In this case, however, something else may be in the works. The Fed’s new “Term Securities Lending Facility” (TSLF) does not involve the usual “open market operations”, in which the Fed prints green pieces of paper called Federal Reserve notes and swaps them for pink pieces of paper called bonds (government I.O.U.s). Rather, the TSLF works like this: the Treasury prints bonds and delivers them to the Federal Reserve, which then trades them with distressed banks for their unmarketable derivative paper. According to Wikipedia, which translates Fedspeak into somewhat clearer terms than the Fed’s own website:
“The Term Securities Lending Facility is a 28-day facility that will offer Treasury general collateral to the Federal Reserve Bank of New York’s primary dealers in exchange for other program-eligible collateral. It is intended to promote liquidity in the financing markets for Treasury and other collateral and thus to foster the functioning of financial markets more generally. . . . The resource allows dealers to switch debt that is less liquid for U.S. government securities that are easily tradable.”
To “switch debt that is less liquid for U.S. government securities that are easily tradable” means that the government gets the banks’ toxic derivative debt, and the banks get the government’s triple-A securities. This improves the banks’ capital position because U.S. securities are considered “risk-free” for purposes of calculating the banks’ “risk-weighted assets.” Risk-laden derivatives are traded for risk-free U.S. securities, reducing the capital the banks must have in reserve in order to make new loans. 2
The beauty of this scheme is that no lender has to be found to underwrite the newly-issued U.S. securities. Federal I.O.U.s are just issued by the Treasury and traded with the banks for their unmarketable derivative debt. The “lenders” holding the government’s I.O.U.s are the distressed banks themselves! But the taxpayers have to pay interest on these securities. The taxpayers are in the anomalous position of paying interest to the banks for the privilege of providing the funds to bail out the banks.
Here are some more references throwing light on what is going on. On September 18, the Associated Press reported:
“The Treasury Department, for the first time in its history, said it would begin selling bonds for the Federal Reserve in an effort to help the central bank deal with its unprecedented borrowing needs. Treasury officials said the action did not mean that the Fed was running short of cash, but simply was a way for the government to better manage its financing needs.”3
For the first time in history, instead of the government borrowing from the Fed, the Fed is borrowing from the government! Yahoo Finance reported on September 17:
“The Treasury is setting up a temporary financing program at the Fed’s request. The program will auction Treasury bills to raise cash for the Fed’s use. The initiative aims to help the Fed manage its balance sheet following its efforts to enhance its liquidity facilities over the previous few quarters.”
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