Thank you, Mr. Chairman. I support extending the TSLF along with the PDCF, and I am also supportive of the proposal to auction options on TSLF draws. I think we do continue to have money market stress, particularly at quarter-end, and it strikes me as a well- targeted program that might have some success in addressing the strains.
On the proposal to extend the term of the TAF loans to 84 days, I do have some qualms, and they have been heightened by our own recent experience with a failing bank and my sense that the most recent bank failure is not going to be our last. I definitely understand the motivation for extending the term of the loans, and I am not saying that I am, on balance, opposed to it. But I do think that the program entails credit risk for Reserve Banks and may actually create complications in facilitating least-cost resolution of troubled banks.
My anxiety about this has been heightened by our own recent experience with IndyMac. If you will indulge me for a second, I will tell you the story of what happened there and why I am concerned. IndyMac was closed on July 11. On June 26, just two weeks earlier, the information provided to us by the OTS indicated that IndyMac was a CAMELS 2–rated institution. We monitored Call Report data that showed it to be well capitalized. On the morning of June 26, we approved a loan for $1 billion under primary credit. IndyMac didn’t participate in TAF auctions, but it was eligible to do so. If the new 84-day facility had been in operation, it would hypothetically have been eligible to be covered under that. It could have had an 84-day TAF loan.
My staff consulted with me on the IndyMac request on that morning of June 26 because it represented a significant escalation in borrowing, and our own monitoring suggested that the institution had been deteriorating. We had informal hints of some concerns at the OTS. It was unknown to us, but in point of fact the OTS had already informed the institution that it had actually been downgraded to a 3. Even so, even if we had known that, it still would have been eligible for primary credit and participation in a TAF auction.
Now, the memo we got points out that we can disqualify an institution from participation in a TAF auction on the grounds that we judge it to be in unsound financial condition or that we can on such a judgment move an institution to secondary credit. But we thought that would be a drastic action, and it probably would have been seen as arbitrary. It would have entailed a supervisory judgment that was in conflict with that of the institution’s supervisor. We didn’t think we had an adequate database to make such a judgment, and we couldn’t have done it without making a formal communication to the institution that we had made such a judgment, which we would have been concerned about. Now, with respect to collateral, we thought we were very much overcollateralized. The institution had pledged collateral with us amounting to around $4 billion. We applied standard haircuts and assigned a lendable value of $3.2 billion, so our credit risk appeared to be very well covered by the collateral, and we approved the loan.
On that very afternoon of June 26, it became public that Senator Schumer had written a letter to the FDIC and the OTS expressing concern about the institution, and that very evening we learned that the OTS had downgraded the institution to a 5, and that, as of June 30, the OTS expected to declare it to be significantly undercapitalized. We also learned that the FDIC was planning to close the institution within a few weeks. We moved it to secondary credit. We took an additional 10 percent haircut on the collateral. That brought IndyMac’s borrowing capacity down to $2.8 billion. But we took the precaution of sending our most senior mortgage specialist from Banking Supervision and Regulation (BS&R) down to the bank to gather information to refine our assessment of the true market value of the collateral, based on that institution’s profile and more detail about the collateral than we had had from applying the standard haircuts. He concluded that the haircuts we were taking were drastically too low and advised us to reduce the lendable value of the collateral down to $1.1 billion. We reserved $100 million for non-Fedwire payment system exposure, leaving us with a $1 billion loan and $1 billion of now-assigned, lendable value of the collateral. So, in retrospect, it turns out that we actually did make a $1 billion loan under primary credit to a troubled institution that was undercapitalized under FDICIA guidelines and on the verge of closure. And we did it based on collateral we should have valued at $1.1 billion rather than $3.2 billion.
So we did have significant credit exposure, and I think we are lucky we lent only overnight and were paid the next day rather than having an 84-day loan. With the TAF, if we had an 84-day loan outstanding on June 26, we would have had no further capacity to assist in the bank’s final days in moving toward what we deemed an FDIC-led least-cost resolution. The bank had lost all access to brokered deposits and also to Federal Home Loan Bank loans after it was downgraded, and our inability to lend any further would almost surely have precipitated a liquidity crisis and a failure well before the FDIC finally closed that institution on July 11.
So let me draw a few morals from this shaggy dog tale. First, troubled banks can be downgraded and fail very rapidly. They may be deemed eligible to borrow under primary credit and participate in TAF auctions when in reality they are near failure. Second, it is true we have discretion to judge whether or not to allow an institution to participate in auctions and can exclude an institution that we don’t consider in sound financial condition. But, in reality, we deal with hundreds and potentially thousands of banks at the discount window and can’t monitor and make independent judgments on the health of all those institutions on an ongoing basis. We do have to rely on primary supervisors for assessments. If we act on our own hunches, we are substituting our judgment for that of primary supervisors. If we decided we wanted to do so, we would be truly taxing the resources of our colleagues in BS&R beyond their capacity to deal with these institutions. Third, we may think that we are overcollateralized, but that judgment can be highly flawed in the case of a troubled institution. Finally, while we may, in principle, demand immediate repayment of any discount window loan, including a TAF term credit, in a failing- bank situation such an action can cause the institution’s immediate failure, making an orderly least-cost resolution impossible. Now, I know that this applies, we hope, to a handful of institutions and not to most of them; but I don’t think that IndyMac is going to be the last failing bank. I do think that this would have worked very badly in that case, and so it does give me qualms about the proposal.