Collateral: a possible connection between investment banks and the sub-prime crisis
September 15, 2008
In attempt to inject liquidity into the anxious markets, the Fed softened its conditions for extending credit:
The Federal Reserve widened the collateral it accepts for loans to securities firms to include stocks in an effort to help Wall Street weather Lehman Brothers Holdings Inc.’s plans for bankruptcy.
This is a daring move, but a very risky one too, as it opens a door to a vicious circle. The markets where the stocks used as collateral are traded are the same markets that are now recording sharp drops… So, the collateral that will now be offered to the Fed for the loans will possibly be worth less, indeed, a lot less, than the loans against which it offered. In fact, if the securities firms use the loans to restore liquidity in the markets (and this is a big ‘if’) then prices will be established at lower level. Hence, even in such a situation, the Fed will be left with under-collateralised debts on its balance sheet. If that reminds you of the sub-prime crisis then you are not alone.