The Federal Reserve's lending programs potentially expose the Federal Reserve to credit risk--the risk that a borrower will not repay a loan. The Federal Reserve mitigates credit risk by requiring collateral for all loans and by monitoring the financial condition of depository institutions and other entities that borrow or may borrow from the Federal Reserve.
Monitoring financial condition
Condition monitoring of depository institutions
Monitoring the financial condition of depository institutions is a four-step process designed to minimize the risk of loss to the Federal Reserve posed by weak or failing depository institutions. The first step is monitoring, on an ongoing basis, the safety and soundness of all depository institutions that access or may access the discount window and the payment services provided by the Federal Reserve. The second step is identifying institutions whose condition, characteristics, or affiliation would present higher-than-acceptable risk to the Federal Reserve in the absence of controls on their access to Federal Reserve lending facilities and other Federal Reserve services. The third step is communicating relevant information about those institutions identified as posing higher risk to staff within the Federal Reserve System and to other supervisory agencies, if and when necessary. The fourth step is implementing appropriate measures to mitigate the risks posed by such entities.
At the heart of the condition monitoring process is an internal rating system that provides a framework for identifying institutions that may pose undue risks to the Federal Reserve. The rating system relies mostly on information from each institution's primary supervisor, including CAMELS ratings, to identify potentially problematic institutions and classify them according to the severity of the risk they pose to the Federal Reserve. Having identified institutions that pose a higher risk, the Federal Reserve then puts in place a standard set of risk controls that become increasingly stringent as the risk posed by an institution grows; individual Reserve Banks may implement additional risk controls to further mitigate risk if they deem it necessary to do so.
Condition monitoring of other borrowers
Monitoring the condition of borrowers other than depository institutions also relies on supervisory information and other information available to the Federal Reserve. For some borrowers, such as some primary dealers, the Federal Reserve has personnel on site at the borrower's place of business. For other borrowers, the Federal Reserve relies largely on information shared by the borrower's primary regulator.
Extensions of credit under the TALF are non-recourse loans, that is, the borrower's obligation to repay the loans is limited to the forfeiture of the collateral. As a result, monitoring the borrower's financial condition is not central to mitigating credit risk associated with these programs; instead, the collateral itself is the key tool for reducing credit risk in these programs, as described below. Extensions of credit through the AMLF were also non-recourse loans.
Collateral policies and requirements
All extensions of credit by the Federal Reserve must be secured to the satisfaction of the lending Reserve Bank by acceptable collateral. Assets accepted as collateral are assigned a lendable value deemed appropriate by the Reserve Bank; lendable value is determined as the market price of the asset less a haircut or, when a market price is not available, an internally modeled fair market value estimate less a haircut. Haircuts reflect credit risk and, for traded assets, the historical volatility of the asset's price and the liquidity or illiquidity of the market in which the asset is traded; the Federal Reserve's haircuts are generally in line with typical market practice. The Federal Reserve applies larger haircuts, and thus assigns lower lendable values, to assets for which no market price is available than to comparable assets for which a market price is available. Borrowers may be required to pledge additional collateral if their financial condition weakens. Collateral is pledged under the terms and conditions specified in the Federal Reserve Banks' standard lending agreement, Operating Circular No. 10. (320 KB PDF)
Collateral for Discount Window loans
Discount window loans, including extensions of credit through the Term Auction Facility (TAF), are made with recourse to the borrower beyond the pledged collateral. Nonetheless, collateral plays an important role in mitigating the credit risk associated with these extensions of credit. The Federal Reserve generally accepts as collateral for discount window loans any assets that meet regulatory standards for sound asset quality. This category of assets includes most performing loans and most investment-grade securities, although for some types of securities (including commercial mortgage-backed securities, collateralized debt obligations, collateralized loan obligations, and certain non-dollar-denominated foreign securities) only AAA-rated securities are accepted. Institutions may not pledge as collateral any instruments that they or their affiliates have issued. A listing of the most commonly pledged asset types and the associated lendable values can be found in the Collateral Margins Table. Many depository institutions that do not have an outstanding discount window loan nevertheless routinely pledge collateral to ensure that they can borrow from the Federal Reserve should the need arise. For a broader overview of the Federal Reserve's Discount Window loan collateral program, please refer to The Federal Reserve System Guide to Discount Window Collateral.
Collateral for loans to securities dealers
Eligible collateral for loans extended through the Primary Dealer Credit Facility (PDCF), which was closed on February 1, 2010, included all assets eligible for tri-party repurchase agreement arrangements through the major clearing banks as of September 12, 2008. The amount of PDCF credit extended to any dealer could not exceed the lendable value of eligible collateral that the dealer had pledged to the Federal Reserve Bank of New York (FRBNY). The pledged collateral was valued by the clearing banks; values were based on prices reported by a number of private-sector pricing services that are widely used by market participants. Loans made under the PDCF were made with recourse beyond the pledged collateral to the primary dealer entity itself. For a broader overview of PDCF policies, please refer to the PDCF terms and conditions and FAQ. Tables that report the collateral margins used in the PDCF are in the collateral and rate setting section of this website.
Loans of securities extended under the Term Securities Lending Facility (TSLF), which was closed on February 1, 2010, were collateralized with other securities rather than cash; that is, a dealer borrowed one security from the Federal Reserve and pledged another security as collateral. Eligible collateral was determined by the Federal Reserve. Two schedules of collateral were accepted. Schedule 1 collateral was Treasury, agency, and agency-guaranteed mortgage-backed securities. Schedule 2 collateral was investment-grade corporate, municipal, mortgage-backed, and asset-backed securities, as well as Schedule 1 collateral. Haircuts on posted collateral were determined by the FRBNY using methods consistent with current market practices. For a broader overview of TSLF and TOP policies, please refer to the TSLF terms and conditions and FAQ and to the TOP terms and conditions and FAQ. Tables that report the collateral margins used in the TSLF are in the collateral and rate setting section of this website.
Collateral for other lending facilities
Under the Term Asset-Backed Securities Loan Facility (TALF), the FRBNY lent on a non-recourse basis to holders of certain newly originated AAA-rated asset-backed securities (ABS) backed by newly and recently originated consumer, business, and commercial mortgage loans. Eligible collateral for the TALF included U.S. dollar-denominated cash (that is, not synthetic) ABS that had a long-term credit rating in the highest investment-grade rating category (for example, AAA) from two or more statistical ratings agencies and did not have a long-term credit rating below the highest investment-grade rating category from a statistical ratings agency. The FRBNY established a process for determining which rating agencies' ratings were accepted for establishing the eligibility of ABS to be pledged as collateral to the TALF. In addition, the FRBNY was required to conduct a formal risk assessment of all proposed collateral. These measures were intended to promote competition among credit rating agencies, ensure appropriate protection against credit risk for the U.S. taxpayer, and ensure that TALF collateral continued to comply with the existing high standards for credit quality, transparency, and simplicity of structure.
The underlying credit exposures of eligible ABS included student loans, auto loans, credit card loans, loans or leases relating to business equipment, leases of vehicle fleets, floor plan loans, insurance premium finance loans, mortgage servicing advances, commercial mortgage loans, and loans guaranteed by the Small Business Administration (SBA). Certain high-quality CMBS issued before January 1, 2009 ("legacy CMBS") were also eligible collateral. Except for legacy CMBS and ABS for which the underlying credit exposures are SBA-guaranteed loans, eligible ABS must have been issued on or after January 1, 2009. All or substantially all of the credit exposures underlying eligible ABS were required to be exposures to U.S.-domiciled obligors. Eligible collateral for a particular borrower could not be backed by loans originated or securitized by the borrower or by an affiliate of the borrower. The FRBNY loaned an amount equal to the market value of the ABS less a haircut; the FRBNY is secured by the ABS and the borrower bears the initial risk of a decline in the value of the ABS. The Federal Reserve set haircuts for each type of eligible collateral; haircuts reflected the riskiness and maturity of the various types of eligible collateral.
Any collateral surrendered to the FRBNY in conjunction with a TALF loan would have been sold to a special purpose vehicle, TALF LLC, established for the specific purpose of managing such assets. Such purchases by TALF LLC would have been at a price equal to the TALF loan plus accrued but unpaid interest, and would have been funded through the commitment fees received by the LLC and any interest the LLC had earned on its investments. Prior to January 15, 2013, the U.S. Treasury's Troubled Asset Relief Program (TARP) committed backup funding to TALF LLC, providing credit protection to the FRBNY; however, after that point in time, the accumulated fees and income collected through TALF and held by TALF LLC exceeded the remaining amount of TALF loans outstanding and, accordingly, the TARP credit protection commitment was terminated. For a broader overview of TALF policies, please refer to the TALF terms and conditions and FAQ.
The Commercial Paper Funding Facility (CPFF), which was closed on February 1, 2010, extended credit to an LLC that purchased three-month U.S. dollar-denominated commercial paper from eligible issuers through the primary dealers. Eligible issuers were U.S. issuers of commercial paper, including U.S. issuers with a foreign parent company. The LLC only purchased commercial paper (including asset-backed commercial paper) that was rated at least A-1/P-1/F1 by an NRSRO. The FRBNY committed to lend to the LLC on a recourse basis; its loans to the LLC were secured by all assets of the LLC. For a broader overview of CPFF policies, please refer to the CPFF terms and conditions and FAQ.
Collateral eligible for the Asset-Backed Money Market Mutual Fund Lending Facility (AMLF), which was closed on February 1, 2010, was limited to asset-backed commercial paper (ABCP) that:
- was purchased by the borrower on or after September 19, 2008 from a registered investment company that holds itself out as a money market mutual fund;
- was purchased by the borrower at the mutual fund's acquisition cost as adjusted for amortization of premium or accretion of discount on the ABCP through the date of its purchase by Borrower;
- was rated not lower than A1, F1, or P1 by at least two major rating agencies at the time pledged or, if rated by only one major rating agency, the ABCP must have been rated within the top rating category by that agency;
- was issued by an entity organized under the laws of the United States or a political subdivision thereof under a program that was in existence on September 18, 2008; and
- had a stated maturity that did not exceed 120 days if the borrower was a bank or 270 days if the borrower was a non-bank.
The qualifying ABCP was transferred to the Federal Reserve Bank of Boston's restricted account at the Depository Trust Company before an advance, collateralized by that ABCP, was approved. The collateral was valued at the amortized cost (as defined in the Letter of Agreement) of the eligible ABCP pledged to secure an advance. Advances made under the facility were made without recourse, provided the requirements in the Letter of Agreement were met. For a broader overview of AMLF policies, please refer to the AMLF terms and conditions and FAQ.
Collateral and risk control for loans to specific institutions
On March 16, 2008, to facilitate the acquisition by JPMorgan Chase & Co. of The Bear Stearns Companies, Inc., the Board of Governors of the Federal Reserve System, under authority provided by section 13(3) of the Federal Reserve Act and with the support of the Secretary of the Treasury, authorized the FRBNY to make a non-recourse loan to a limited liability company (Maiden Lane LLC) that would acquire roughly $30 billion of particular, less liquid assets of Bear Stearns. The loan was to be repaid from the proceeds of the orderly disposition of these assets over time, plus any earnings derived from the assets prior to sale. The loan was secured by all of the assets acquired by Maiden Lane LLC and by a subordinated loan of $1.1 billion from JPMorgan Chase & Co. to Maiden Lane LLC that would absorb any initial losses on the assets up to that amount. The LLC managed the assets through time to maximize repayment of the credit extended and to minimize disruption to financial markets. On June 14, 2012, the loan from the FRBNY to Maiden Lane LLC was repaid in full, including interest. On November 15, 2012, the FRBNY announced the full repayment of the subordinated loan made by JPMorgan Chase & Co., plus accrued interest. The FRBNY is entitled to any residual cash flow generated from the remaining Maiden Lane LLC assets.
On September 16, 2008, the Federal Reserve, with the full support of the Secretary of the Treasury, approved under section 13(3) of the Federal Reserve Act the establishment by the FRBNY of a revolving credit facility for American International Group, Inc. (AIG). Subsequently, on November 10, 2008, the Board and the Department of the Treasury announced the restructuring of the U.S. government's support for AIG. Under the restructuring, two LLCs were formed and funded largely by the FRBNY. Maiden Lane II LLC was formed to purchase residential mortgage-backed securities from AIG; and Maiden Lane III LLC was formed to purchase multi-sector collateralized debt obligations (CDOs) on which AIG had written credit default swaps and similar contracts. The full portfolios of assets held by Maiden Lane II LLC and Maiden Lane III LLC served as collateral for the FRBNY's loans to the respective LLCs.
AIG was unconditionally obligated to repay the unpaid principal amount of all advances under the revolving credit facility, together with accrued and unpaid interest thereon and any unpaid fees. All outstanding balances under the revolving credit facility were secured by the pledge of assets of AIG and its primary non-regulated subsidiaries, including AIG's ownership interest in its regulated U.S. and foreign subsidiaries. Furthermore, AIG's obligations to the FRBNY were guaranteed by each of AIG's domestic, nonregulated subsidiaries that have more than $50 million in assets. These guarantees themselves were separately secured by assets pledged to the FRBNY by the relevant guarantor.
The FRBNY's agreement to provide advances under the revolving credit facility was specifically conditioned on the FRBNY being satisfied in its sole discretion with the nature and value of the collateral securing AIG's obligations at the time of the advance, and on the FRBNY being reasonably satisfied in all respects with the corporate governance of AIG. Representatives of the FRBNY were in regular contact with AIG's senior management and attended all AIG board of directors meetings, including committee meetings, as observers. The FRBNY also had staff on site at AIG to monitor the company's funding, cash flows, use of loan proceeds, and progress in pursuing its global divestiture plan.
On January 14, 2011, AIG repaid in full the amount then outstanding on the FRBNY revolving credit facility, including accrued interest and fees, and the FRBNY's commitment to lend any further funds was terminated.
In March 2011, the FRBNY began to dispose of securities in the Maiden Lane II LLC portfolio through competitive sales. On March 11, 2012, proceeds from these asset sales, along with cash flow generated by the securities while held in the Maiden Lane II portfolio, enabled the repayment in full of the loan from the FRBNY to Maiden Lane II LLC, with interest. In April 2012, the FRBNY began to dispose of securities in the Maiden Lane III LLC portfolio through competitive sales. On June 14, 2012, proceeds from these asset sales, along with cash flow generated by the securities while held in the Maiden Lane III portfolio, enabled the repayment in full of the loan from the FRBNY to Maiden Lane III LLC, with interest. That repayment marked the retirement of the last remaining debts owed to the FRBNY from the crisis-era interventions with AIG.
Implications for Federal Reserve earnings
An extension of credit through any of the Federal Reserve's lending facilities is an asset on the Federal Reserve's balance sheet. Any loss in the value of these assets would reduce Federal Reserve earnings. As discussed in the section that explains the Federal Reserve's balance sheet, earnings in excess of the amount needed to defray Federal Reserve expenses and to equate surplus with capital paid in are remitted to the Treasury; as a result, any loss associated with lending programs would reduce the payment that the Federal Reserve remits to the Treasury. If such losses were to become so great that the Federal Reserve's net earnings were not large enough to equate surplus with capital paid in, payments to the Treasury would be suspended until such time that earnings had made up the shortfall. The Federal Reserve's financial reports shows the Federal Reserve System's net income and the payments it makes to the Treasury.
Payment System Risk
In addition to the lending described above, the Federal Reserve extends credit to depository institutions on an intraday basis to promote effective functioning of the payment system. On March 24, 2011, the Federal Reserve implemented changes to its Payment System Risk policy (PDF).