I ran across this memo from the merry band of pranksters at the Federal Reserve legal division. The memo explains why the Fed could legally buy unsecured commercial paper during the financial crisis–that is, make unsecured loans to businesses–even though under the relevant legal authority the loans must be “secured to the satisfaction” of the Fed.
The lovable lawyers make two arguments. Argument 1 is that the Fed didn’t actually make loans to the businesses. It made loans to a special purpose vehicle that the Fed created. The SPV then turned around and loaned the Fed’s money to the businesses. The Fed’s loan to the SPV was secured by the commercial paper that the SPV acquired from the businesses in return for its (the Fed’s) money.
According to this theory, any unsecured loan to anyone can be converted into a secured loan simply by creating an SPV. You can do it yourself. Just create an SPV, lend money to the SPV, direct the SPV to lend that money to Mr Anyone in return for an IOU from him, and then call the IOU collateral for your loan to the SPV. Voila, an unsecured loan to a person with no assets turns into a secured loan.
Argument 2 is even more clever. The lawyers grudgingly admit that their first argument might be considered specious (they don’t use exactly that word) since as a matter of function the SPV doesn’t do anything at all. So in Argument 2, the lawyers observe that the Fed charges the unsecured CP issuers an “insurance fee” or premium of 1% above the normal interest rate. The “insurance fees” from all the unsecured borrowers are aggregated into an “insurance fund,” which can then pay out to the Fed if any borrower defaults. This insurance fund gives the Fed “security.”
Of course, an unsecured loan always carries a higher interest rate than a secured loan does. That higher interest rate–or call it the “insurance fee” if you want–has precisely the function of protecting the creditor from the extra risk from lending to a borrower who cannot offer collateral. So by the Fed’s logic, any unsecured loan is a secured loan as along as the interest rate for the unsecured loan is higher, as it always is. In short, there is no such thing as an unsecured loan; all unsecured loans are secured.
Happy Love Your Lawyer day!