[NYTr] Fed waives rules so banks can underwrite their brokerages more

[All the News That Doesn't Fit]

CNN via GATA - Aug 24, 2007
http://money.cnn.com/2007/08/24/magazines/fortune/eavis_citigroup.fortune/index.htm?postversion=2007082417


Fed waives rules so banks can underwrite their brokerages more

By Peter Eavis
Fortune magazine via CNNMoney

NEW YORK -- In a clear sign that the credit crunch is still affecting
the nation's largest financial institutions, the Federal Reserve
agreed this week to bend key banking regulations to help out Citigroup
and Bank of America, according to documents posted Friday on the
Fed's web site.

The Aug. 20 letters from the Fed to Citigroup and Bank of America
state that the Fed, which regulates large parts of the U.S. financial
system, has agreed to exempt both banks from rules that effectively
limit the amount of lending that their federally-insured banks can
do with their brokerage affiliates.

The exemption, which is temporary, means, for example, that Citigroup's
Citibank entity can substantially increase funding to Citigroup
Global Markets, its brokerage subsidiary. Citigroup and Bank of
America requested the exemptions, according to the letters, to
provide liquidity to those holding mortgage loans, mortgage-backed
securities, and other securities.

This unusual move by the Fed shows that the largest Wall Street
firms are continuing to have problems funding operations during the
current market difficulties, according to banking industry skeptics.

The Fed's move appears to support the view that even the biggest
brokerages have been caught off guard by the credit crunch and don't
have financing to deal with the resulting dislocation in the markets.
The opposing, less negative view is that the Fed has taken this
step merely to increase the speed with which the funds recently
borrowed at the Fed's discount window can flow through to the bond
markets, where the mortgage mess has caused a drying up of liquidity.

On Wednesday, Citibank and Bank of America said that they and two
other banks accessed $500 million in 30-day financing at the discount
window. A Citigroup spokesperson declined to comment. Bank of America
dismissed the notion that Banc of America Securities is not
well-positioned to fund operations without help from the federally
insured bank. "This is just a technicality to allow us to use our
regular channels of business with funds from the Fed's discount
window," says Bob Stickler, spokesperson for Bank of America. "We
have no current plans to use the discount window beyond the $500
million announced earlier this week."

There is a good chance that other large banks, like J.P. Morgan,
have been granted similar exemptions.

The Federal Reserve and J.P. Morgan didn't immediately comment.

The regulations in question effectively limit a bank's funding
exposure to an affiliate to 10% of the bank's capital. But the Fed
has allowed Citibank and Bank of America to blow through that level.
Citigroup and Bank of America are able to lend up to $25 billion
apiece under this exemption, according to the Fed. If Citibank used
the full amount, "that represents about 30% of Citibank's total
regulatory capital, which is no small exemption," says Charlie
Peabody, banks analyst at Portales Partners.

The Fed says that it made the exemption in the public interest,
because it allows Citibank to get liquidity to the brokerage in
"the most rapid and cost-effective manner possible."

So, how serious is this rule-bending?

Very.

One of the central tenets of banking regulation is that banks with
federally insured deposits should never be overexposed to brokerage
subsidiaries; indeed, for decades financial institutions were legally
required to keep the two units completely separate. This move by
the Fed eats away at the principle.

Sure, the temporary nature of the move makes it look slightly less
serious, but the Fed didn't give a date in the letter for when this
exemption will end. In addition, the sheer size of the potential
lending capacity at Citigroup and Bank of America -- $25 billion
each -- is a cause for unease.

Indeed, this move to exempt Citigroup casts a whole new light on
the discount window borrowing that was revealed earlier this week.
At the time, the gloss put on the discount window advances was that
they were orderly and almost symbolic in nature. But if that were
the case, why the need to use these exemptions to rush the funds
to the brokerages?

Expect the discount window borrowings to become a key part of the
Fed's recovery strategy for the financial system. The Fed's exemption
will almost certainly force its regulatory arm to sharpen its
oversight of banks' balance sheets, which means banks will almost
certainly have to mark down asset values to appropriate levels a
lot faster now. That's because there is no way that the Fed is going
to allow easier funding to lead to a further propping up of asset
prices.

Don't forget: The Federal Reserve is in crisis management at the
moment. However, it doesn't want to show any signs of panic. That
means no rushed cuts in interest rates. It also means that the Fed
wants banks to quickly take the big charges that will inevitably
come from holding toxic debt securities. And it will do all it can
behind the scenes to work with the banks to help them get through
this upheaval.

But waiving one of the most important banking regulations can only
add nervousness to the market. And that's what the Fed did Monday
in these disturbing letters to the nation's two largest banks.