How the Fed Prepared to Buy Bank Stocks in 2007: Street Whispers

NEW YORK ( TheStreet) -- As the U.S. subprime housing market went into meltdown in 2007 and brought Wall Street to its knees -- leading to trillions in bailout measures -- some officials in the Federal Reserve were ready to buy up bank stocks.

Little did they know by 2008 it would be all but impossible for the Fed not to hold them despite stated policies against equity ownership.

While transcripts of meetings from 2007 released on Friday provide a glimpse into the Fed's slow recognition of the cracks in megabanks that would imperil the global economy, poorly timed comments like one governor's hypothetical recommendation to buy bank shares near pre-crisis stock highs also foreshadow the extreme and still unknown steps that the central bankers took to rescue Wall Street when the crisis hit.

According to transcripts from a Sept. 18, 2007 meeting, then-Governor Frederic Mishkin recommended that the Fed consider buying bank stocks given the bright long-term prospects of the financial sector, particularly in originating home loans if lending standards improved.

"In particular, we've gone to an originate-to-distribute model, which Fed Governor Randall Kroszner mentioned, and we have found some serious flaws in it. The expectation is that we will have new models coming out. In fact, I think that this is actually going to be a long-run profit opportunity for the banks. So if we were allowed to buy bank stocks, I think it would be a good idea," says Mishkin.

" Laughter," is the reaction of Fed officials to Mishkin's idea, according to the Fed's transcript.

Mishkin's recommendation was used as a hypothetical to describe the health of the U.S. financial system when early signs of crisis emerged. Still, it raises key unanswered questions from the financial crisis and the Fed's unprecedented action.

Notably, the mid-September meeting was the first where the Fed considered novel programs to dramatically expand its balance sheet and provide relief to America's largest banks and Wall Street dealers. Within months of the meeting, the Fed would be pumping trillions into the banking system and taking assets in return such as equities and complicated debt instruments it previously considered unacceptably risky.

While the Fed might not have bought bank shares as Mishkin recommended in 2007, it may very well have held them as collateral against emergency loans during the crisis.

At the Sept. 2007 meeting, one of the first to occur after clear signs of crisis emerged and propelled the central bank into action, Mishkin detailed his impressions of the potency of a housing market bust for the financial sector, characterizing it as somewhere between quick crises such as the failure of hedge fund Long Term Capital Management and the Sept. 11, 2001 terrorist attacks, and more structural collapses such as the savings and loan crisis.

The key question Mishkin raised in the Sept. 2007 meeting was whether the Fed should use its 'lender of last resort' powers, as it did in the LTCM crisis and the 9/11 terrorist attacks, or whether issues were beyond its purview.

"The problem here is really the interaction of the financial side with the real side. I'm worried that, as the economy becomes more nonlinear, we have the potential for a vicious circle or a downward spiral... So the big issue here for me is that this nonlinear element is very real right now. The question is what to do about it, and that's what we will be discussing shortly," says Mishkin, in his analysis.

It's precisely the Fed's actions, increasing in their creativity and desperation through the crisis, which makes Mishkin's hypothetical of buying shares in banks ironic.

In the Sept. 18, 2007 meeting, the Fed first broached the idea of a program, eventually called the Term Auction Facility, which would pump safe assets into banks and temporarily cast off risky ones onto the Fed's balance sheet. In TAF, the Fed offered trillions in repurchase arrangements where it would auction off safe assets to banks and take riskier and less liquid ones such as mortgage backed securities off their books for as long as 28-days.

The program was intended to help pump money into increasingly illiquid banks and alleviate strains in the financial system that could harm the real economy, as Mishkin and some Fed officials worried in 2007. Notably, Fed transcripts reveal the program was designed to allow banks to access the Fed's funds in a manner that wouldn't indicate their duress, unlike the so-called 'discount window.'

"By allowing the Federal Reserve to inject term funds through a broader range of counterparties and against a broader range of collateral than open market operations, this facility could help promote the efficient dissemination of liquidity when the unsecured interbank markets are under stress," the Fed stated in a Dec. 12, 2007 press release announcing TAF.

TAF would eventually beget even riskier operations conducted by the Fed such as the Primary Dealer Credit Facility, Term Securities Lending Facility, Term Asset-Backed Securities Loan Facility and direct toxic asset portfolio buys from JPMorgan Chase ( JPM)-owned Bear Stearns and AIG ( AIG), in an effort to give banks cheap short-term funding and ease the burdens of risky assets on their books.

It's in the Primary Dealer Credit Facility, an eventual $9.7 trillion program, where the Fed very well may have heeded Mishkin's recommendation and bought bank stocks - by way of overnight repurchase agreements with Wall Street dealers.

PDCF was an overnight lending facility created by the Fed, which was targeted at securities dealers and accepted new forms of collateral as risky as equities, low-rated debts, and unknown unrated financial instruments, in order to help investment banks finance themselves when short term funding markets dried after the collapse of Bear Stearns.

According to data released to the public by the Fed between Sept. 15, 2008 and May 5, 2009, PDCF accepted roughly $2.18 trillion in equity securities as collateral for overnight funds, primarily from investment banks Bank of America Merrill Lynch ( BAC), Morgan Stanley ( MS), Goldman Sachs ( GS) and Barclays ( BCS). The Fed's public data, however, doesn't show what equities those holdings were in. Presumably, some were in bank stocks.

More granular data was sent to Bloomberg after the news agency won a multi-year Freedom of Information Act battle with the Fed that went all the way to the U.S. Supreme Court. Bloomberg has since made those documents public, however, the data doesn't appear to specify the Fed's holdings beyond a daily breakdown of its collateral by bank and asset type.

As Bloomberg noted, much of the PDCF data raises more questions about the crisis than it answers -- for instance, the $1.5 trillion in collateral the Fed accepted with a moniker 'ratings unavailable.' In total, roughly $9 trillion was lent to dealers in PDCF, backed by $9.67 trillion in collateral.

Overall, the Fed's various crisis-time facilities expanded the central bank's balance sheet by about $3 trillion, pumping that amount into U.S. financial system.

While Fed Governor Mishkin's Sept. 18, 2007 recommendation that the Fed buy up bank stocks proved a light moment at the time, it also foreshadowed the unthinkable action the central bank would take as the financial crisis intensified in 2008. Transcripts to 2008 Fed meetings will be released next year.

For more on the Fed's Friday disclosure, see inside the Fed's first financial crisis meeting. Also see Jim Cramer's reflections on the Fed's inaction in mid-2007.

-- Written by Antoine Gara in New York

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