This is gross leverage, so it is just equity—in this case, a ratio of equity over total assets—a very blunt measure.
Page 6 gives us a more current view. In the left-hand panel is the tier 1 capital ratio for the four largest securities firms. As I think you know, the SEC has made a decision to use and hold investment banks to a Basel II ratio that’s consistent with how the bank supervisors apply it. To date, the firms have not disclosed those ratios. That begins this quarter, the second quarter. For Goldman, Lehman, and Morgan Stanley, that quarter ended May 31, 2008, so we show the estimated ratios there. These were not in their earnings releases, although they were picked up by some of the analysts in their conference calls—so these numbers are seeping out there. Merrill reports on a bank cycle, June 30, so they have not yet released their tier 1 capital ratio.
A couple of takeaways from the left side of this page: First, the quarter has not ended, but Merrill was obviously low compared with its peers. They do have the benefit of seeing and being aware of where their peers have come out, so we shall see if Merrill takes some action in the near term to bolster capital. The second point is that the investment bank ratios look fairly high compared with where the commercial bank tier 1 capital ratio would be. There are a couple of reasons for that. First, the assets of the investment banks are concentrated in the trading book, so there are two issues there. Those assets tend to have a lower credit charge. The other issue, which we have to do more work on, is that we need to understand better the modeling methodologies and the model approvals that the SEC has given these firms to compute tier 1 capital. That could be a significant factor as well. So at first blush they look very healthy, very high; but I think it will take more analysis to get beneath those.
The right-hand side of page 6 gives another way of looking at capital—what we call an “FRBNY-adjusted leverage ratio.” What we’re trying to do here is to have another way of putting investment banks and commercial banks on a somewhat similar footing. So in terms of the numerator, we use tangible equity for two reasons. First, it’s a higher form of equity capital, perhaps the highest form. Second and just as important, it avoids current differences between how investment banks and commercial banks calculate tier 1 capital. Right now there’s a grandfathering period in which the securities firms are allowed to carry a higher portion of subordinated debt in tier 1 capital. It does not apply to bank holding companies. This puts them on more of an equivalent basis in terms of the numerator. The deal is the same with the denominator. Again, we’re trying to make allowances for the differences in business models. So here we subtract from the denominator secured financing assets. These are reverse repos and securities borrowings. Of course, these are collateralized by cash and thus are relatively low-risk assets. So by making those two adjustments, we have a somewhat comparable view. The takeaway here is that they don’t look too far apart—they are not dissimilar—at least at this point in the cycle.
Why don’t we move now to page 7, to liquidity? I have a picture of liquidity, but not a full picture. This shows the trend in parent company liquidity pools. This is unencumbered cash or high-quality securities at the parent company of the four investment banks. As you can see, the trend has been increasing since the middle of March. The general trend has been to increase. This, of course, tells us only half the story because one wants to know what that pool is held against. So, let’s turn to page 8, and I can talk a bit about how we’re trying to look at and assess this.
We’ve been engaged with the SEC and have entered into an approach in trying to assess liquidity at the four investment banks. When we first started this endeavor back in late March, the first thing we did was to go back to the firms and to say, “Show us what would happen to liquidity if you experienced a Bear Stearns, full-run kind of scenario? For that exercise we want to know what assets you have eligible for the PDCF. We want to know how bad and how dark it would get.” That exercise was pretty demanding. No one would have passed the test. We looked at that and asked whether a full run on the institution was an appropriate way to look at it or an appropriate standard to hold them to. So we came up with another scenario that we put back to the firms. We basically said, “Listen, we want you to do a stress analysis for us. Look at something that’s pretty severe but short of a full Bear Stearns scenario. Look out over thirty days. By the way, you have no access to the PDCF. Let’s see how that looks.” We’re in the process of doing that right now. The table on the left gives you an idea of some of the things that we’re looking at and how we’ve asked the firms to provide the information to us. Basically there are several buckets: (1) their unsecured and secured funding; (2) what comes on the balance sheet under stress, either general market stress or firm-specific stress; and (3) the impact from operating cash flows toward the bottom. Those are the combination of liquidity claims that they would face under stress. The last piece is the additional funding from affiliated or unaffiliated bank lines along with, obviously, the liquidity pool, which we have separately. Basically, we’re engaged in an exercise in which we compare and converge assumptions. We’ve had multiple discussions with each of the four firms, trying to understand where their assumption differed and trying to converge those. We then constructed, or are in the process of constructing, a cash flow analysis. Again, we are relating their cash needs under stress, given these assumptions, to their available liquidity pool plus the unaffiliated or affiliated bank lines that can be drawn.
The drivers here, obviously, are going to be the mix and term of secured funding, which is going to be a big driver in terms of the liquidity needs, as well as some of the operating cash flow assumptions that firms make in looking at a stress scenario. We are fairly close to pulling together information with which we can construct an analysis, go back to the firms, share with them our assessments of where they are, and give them a chance to explain to us how we were spot on or where we may have missed certain things. But those conversations will happen in the near future. So that’s basically what we’re doing in terms of liquidity. It has been an interesting exercise. I think that there is no simple way to look at liquidity but that this is the best way to do so.
Let’s turn to page 9. I have just a few words about the use of both the PDCF and the TSLF. I have graphs later on the TSLF. A graph of the PDCF usage would be kind of boring. It would show Bear Stearns as far and away the dominant borrower. Actually I think Bill Dudley conveyed to you yesterday that Monday was their last night of borrowing under the PDCF. So Bear Stearns is now out. Until very recently there were three others that I’ll call chronic users of the PDCF. First, we had Cantor. I’ll say a few words about that. They started borrowing in late March, initially $600 million to $700 million. They stabilized in mid-April at about $500 million. We saw that borrowing coming in every night. Members of the team here spent one afternoon at Cantor at the end of April. We asked them for some information in advance. We spent a good chunk of time with them. We came away not being comfortable with the number or the size of their borrowings in relation to the firm’s capital. We then consulted with our colleagues in both the Legal and Markets Groups. We asked Cantor to submit a plan to wean itself from the PDCF and to submit that to us in writing. We then followed up with a friendly letter from Mr. Dudley and Mr. Baxter asking for a little more information and a little more specificity. They got the point. They started to bring that down in accordance with the schedule they gave to us. In fact, they ended up winding down to zero in their borrowing last week, ahead of schedule, and they obtained third-party financing. So that was the Cantor story.
Countrywide was a somewhat similar situation. They had been borrowing from day 1 of the PDCF. Initially they would ask us for $1 billion. They had borrowed and stabilized at about $900 million. Our Markets Group initiated a conversation with Countrywide Securities at the end of May. In short, we were uncomfortable with, in essence, providing bridge financing to the close of the acquisition by Bank of America. We felt some vulnerability there. So our initial salvo or proposal back to Countrywide Securities was that they needed to wind down the use of section 13(3) facilities by the end of June—both the PDCF and the TSLF. They came back to us and in essence said, “Well, couldn’t you just let us go into July a bit because our merger is supposed to be approved today actually by the Bank of America board? Our legal Day 1, our closing is July 1. We can transfer positions July 2. What’s a couple of days among friends?” We had a little negotiation back and forth. We reached, I think, an agreement that was amenable to all. They agreed to wind down their use of the TSLF—no new borrowings. They could swing some of that into the PDCF. We would allow them to go until the closing, July 2, when they could transfer those positions. In return we got a little extra margin. So, in effect, those borrowings were being collateralized at a margin of roughly 7 percent. We got an additional 13 percent, bringing us to 20 percent, which will bring us through until July 2. So I think all sides are reasonably comfortable there, and with friendly persuasion, Dudley and Baxter sealed the deal there.
Let me say a few words about Barclays Capital. We handled this a bit more informally. They started using the PDCF more in late March, at around $5 billion. They got to a peak of about $7 billion. Both Bank Supervision and Markets had conversations with Barclays, asking them to tell us a little more about why they were using this. What’s the rationale? They had a consistent story. They would tell us that it was economically advantageous for them to use that. They thought it was good. In one conversation with our colleagues in the Markets Group, one of the traders conveyed that Barclays thought they needed to support the TSLF in much the same way that they supported open market operations. Our colleagues in Markets very quickly disabused them of that notion. After a couple of conversations, they got the message. They eventually ceased borrowing from the PDCF around the beginning of June. So as of now, the only outstanding we have is with Countrywide Securities, and that should come to a close next week, knock on wood.
Again just for the sake of completeness, on page 10 I’ll talk about the TSLF usage. First, schedule 1, which is OMO-eligible collateral—as you can see among the primary dealers, Merrill has had the highest amount outstanding. Merrill is, I guess, the tan line. The biggest users have been the commercial banks—Deutsche Bank is up top, a pretty consistent user. Then Citigroup (the green line), which has also been a fairly consistent and heavy user. Let’s turn to schedule 2 (page 11), which is the less liquid collateral. Here among the primary dealers, Lehman (the blue line) has been the most consistent user, followed by Merrill Lynch. As you can see, UBS among the banks was clearly far and away the biggest user, although within the past two weeks they have reduced their TSLF borrowings. So that’s, very briefly, the top five. There’s again a bit of a mix here. But as you can see, the investment banks are not the biggest users of the TSLF.
Let’s turn to page 12, and I’ll finish up here. I’ll just highlight a very near-term challenge that we face, and I think it will provide a nice transition to Scott’s and Pat’s portions of the briefing. I don’t want to get too much into their sections. But I think generally we have an issue. I think that, the longer we stay on site with this effort, the reputational risk to the Federal Reserve increases. As Governor Kohn testified last week, we’re not examining; we are just very narrowly focused. I think that message was well received. At this time, it’s not too problematic. But if someone is up on the Hill six months or a year from now, I think it’s going to be very difficult to say that we’re just doing this liquidity and capital thing. People are going to want to know a little more about our judgments and how we made those judgments. As I said early on, I think there’s some risk to making those judgments without having a little more information. So I think the trick for us is, if we have our traditional bank supervision model on the left and what we’re doing right now on the right, we have to move this way, more to the left. By no means should we be way over here. But I think we have to figure out how to get this way a little more. With that, I will end my remarks and pass to Scott and then to Pat.