WASHINGTON — With the Federal Reserve Board poised to expand its consumer lending program to accept many of the bad assets held by financial institutions as collateral, the central bank is crossing into a new — and risky — era.
Since the onset of the financial crisis, the Fed generally has been reluctant to accept big risks. Though it took on some of the worst holdings from Bear Stearns Cos. and American International Group Inc., its other liquidity programs accepted only highly rated securities as collateral.
That changed Monday when the Treasury Department said the Fed would accept the toxic assets on bank balance sheets as collateral for loans under the Term Asset-Backed Securities Loan Facility. The shift could spell more risk for the Fed while further stripping it of the political independence that has made it a Washington powerhouse.
"The Fed is doing what a central bank should never do: take on many highly risky assets," said Allan Meltzer, a professor at Carnegie Mellon University and a noted Fed historian. "The Fed sacrificed its independence earlier in this crisis, so it did not have much more to give up."
The big question is whether those assets will end up on the Fed's balance sheet, and whether the central bank will ever be able to sell them.
"To the extent that there's no market for them, then we're going to be stuck with them until a market evolves," said Cornelius Hurley, a former Fed lawyer who is now the director of the Morin Center for Banking and Financial Law at the Boston University School of Law. "We're stepping into the shoes of the banks."
Others said the government needs to accept losses on assets if that is what it takes to salvage the financial system.
"I consider it a necessary evil," said Kevin Jacques, a former Treasury official who now chairs the finance department at Baldwin-Wallace College. "We may see some very risky assets ballooning on the Fed's balance sheet."
Under the program, the Fed lends against assets offered by banks as collateral. The assets, initially limited to securities backed by auto, credit card, student and small-business loans, stay on the bank's balance sheet unless the Fed decides to call the collateral.
The goal was originally to liquefy the markets for consumer debt by providing investors an incentive to buy the securities. Observers say the revamp complements the Treasury's larger plan by allowing banks to tap liquidity while holding on to assets they might not want to sell to the government.
"There are some banks that don't want to get them off the balance sheets and feel they're getting enough of a capital return," said Peter Vinella, the global head of financial services for the consulting firm LECG. The Fed and Treasury are "trying to create a program to cover the entire gambit."
Initially the facility accepted only collateral that was originated after Jan. 1 and received the highest ratings from their ratings firm. But the Treasury substantially weakened those provisions and said Monday that the holdings merely needed a triple-A rating at the time of origination, which could now include dates before this year.
"There are huge amounts" of securities that have been downgraded since origination, said Karen Shaw Petrou, the managing director of Federal Financial Analytics Inc. "Many of them are junk or below now."
But Vinella said the Fed is still protected from some of the worst assets plaguing the industry, such as subprime mortgages, which never received triple-A ratings.
"If you look at it, they didn't take on the really funky stuff," he said. "These are more the ones where there's a liquidity issue, but it's not in default."
Still, some are wondering whether the central bank is capable of managing troubled assets as well as other regulators, like the Federal Deposit Insurance Corp.
"I just don't think the Fed, like the FDIC, has a long history of dealing with troubled assets," Hurley said. "They will have to contract out, but they still have to manage the people they hire."
The facility has gone through several iterations since the Fed unveiled it in November, and observers said many questions remain unanswered. Prominent among them is what type of haircut the Fed might take on loans against toxic assets.
The Fed said last month that haircuts would range from 5% to 16%, depending on the asset and its maturity. But Treasury's fact sheet said haircuts "will be determined at a later date and will reflect the riskiness of the assets."