Sunday, 6 April 2008

A brief look at U.S. Fed's new credit facility programs

It appears that the U.S. Federal Reserve, together with top heads from the financial services industry, are working overtime lately to come up with the new creative ways to save the butts of U.S. and global banks. Up until recently, what did we remember from our college economics courses about the Fed’s monetary-policy tools? Each good student knew that there were three key tools that the Fed used to conduct its monetary policy: open market operations based on repo transactions with Treasury securities, the discount window for overnight bank borrowing, and the more fundamental reserve requirement.

Well, we now have several brand-new additions to this family. The picture has changed dramatically over the last several months, as the Fed was desperately trying to prevent the U.S. financial system from the biggest and most deadly collapse in the U.S. history. From now on, students will have to memorize and understand three (!) new policy terms which can be conveniently labeled under one common title: Fed’s lending facilities.

This post provides a short description of each of the three new facility types, which include: (1) the Term Auction Facility (TAF); (2) the Term Securities Lending Facility (TSLF); and (3) the Primary Dealer Credit Facility (PDCF). Let’s go over each one of them in a bit more detail.

1. Term Auction Facility (TAF)

Since December 17, 2008, the Term Auction Facility program offers short-term fixed-amount funding to U.S. depository institutions via regularly scheduled bi-weekly auctions. All depository institutions that are eligible to borrow under the primary credit program are eligible to participate in TAF auctions as well. Although first introduced with the intention of being used as a temporary policy tool, TAF auctions now feel like a regular affair which will be used continuously for quite a while.

Each TAF auction is a closed-bid auction for fixed loan amounts which are a part of a total lending facility with a pre-set credit limit, with a fixed rate determined by the auction process (subject to a minimum bid rate). The stop-out rate at the March 25, 2008 auction was 2.615%, which in my opinion is a very good deal for those banks that are unable to secure affordable financing amid increasingly troubling developments in the U.S. financial sector. The regular term of TAF loans is set at 28 days. The collateral requirements on TAF loans are similar to collateral requirements on discount-window borrowing, which include (if I am correct) Treasury securities and AAA-rated government agency debt. Originally, the total monthly facility size was set at U.S. $30+30 billion = $60 billion. However, during the last month, the Fed has increased the originally planned monthly size of its TAF auctions from $60 billion to $100 billion. My feeling is that this increase is not the last one.

My resume on TAF: This facility is basically a crippled and limited centralized, government-backed alternative to the severely damaged market of financial commercial paper, which was closely associated with rollover financing of longer-term asset-backed security instruments. The banks would probably like to get a lot more than a fairly modest $100 billion, which looks rather pale in comparison with the outstanding cumulative risk exposure in the finanical services sector. They will definitely need much more to cover up the gaps in financing and to meet their payment obligations on the asset-backed and derivative junk. There are currently only a few volunteers to lend money to the banks in the open marketplace, given the amounts of so called asset-backed toxic junk on their balance sheets and even bigger amounts of off-balance-sheet derivatives that many of them created and traded. To make the matters worse, banks themselves are not willing to lend money to each other, even though traditionally the interbank lending markets were one of the most important sources of short-term financing for the largest banks.

The current size of TAF lending alone is definitely not enough to control the situation, therefore the Fed came up with a couple of other fresh ideas by starting lending Treasuries and cash to the selected largest banks via the Term Securities Lending Facility and the Primary Dealers Credit Facility.

2. Term Securities Lending Facility (TSLF)

The TSLF became the second new tool created by the U.S. Fed over the last four months. The new facility was introduced by the Fed on March 11, 2008. According to information posted on the Fed’s website, “the TSLF is a 28-day facility that will offer Treasury general collateral (“GC”) to the Federal Reserve Bank of New York’s (“FRBNY”) primary dealers in exchange for other program-eligible collateral. It is intended to promote liquidity in the financing markets for Treasury and other collateral and thus to foster the functioning of financial markets more generally.”

Aside: The primary dealers are the 20 large banks and securities firms that trade directly with the Fed. The current list of primary dealers can be checked here. The familiar faces in this group of potential insolvency and litigation candidates include J.P. Morgan, Bear Stearns, Lehman, Goldman, Merrill, Countrywide, UBS, HSBC, and Citigroup. See my earlier post on banking derivatives and you will understand why I am so sceptical about the long-term fate of these guys.

The size of the first TSLF auction conducted on March 27, 2008 was $75 billion, but the Fed indicated that the facility monthly limit can be expanded further up to $200+ billion. According to the Fed, in addition to regular collateral eligible for open market repo agreement transactions, the eligible collateral for TSLF lending includes “AAA/Aaa-rated private-label residential mortgage-based securities (MBS) and commercial MBS, as well as agency collateralized mortgage obligations (CMO) that are not on review for downgrade.”

Further, "the TSLF is a single-price auction, where accepted dealer bids will be awarded at the same fee rate, which shall be the lowest fee rate at which any bid was accepted. Dealers may submit two bids for the basket of eligible general Treasury collateral at each auction...At the TSLF auction, each dealer aggregate award is limited to no more than 20 percent of the offering amount."

The important difference between the TSLF and the TAF is that the TSLF is a bond-for-bond lending tool, as opposed to the cash-for-bond TAF financing, and it does not have an explicit impact on reserve levels in the banking system. Also, the auctions for TSLF borrowing are weekly and thus can be used more regularly and easily by the primary dealers than bi-weekly TAF auctions for banks. However, the collateral part is basically the key innovation component of TSLF lending. Essentially, what we have here is an opportunity for largest banks and securities firms to exchange the "top-rated" asset-based securities on their balance sheets for the less risky and more liquid Treasuries, which can be used as collateral in the “regular” market to secure cash financing by the big banks. In other words, by lending Treasuries to the major dealer banks, the Fed indirectly gives them a relatively low-cost opportunity to raise extra financing.

3. Primary Dealer Credit Facility (PDCF)

On March 16, 2008, the Fed announced introduction of the third new tool, the Primary Dealer Credit Facility, which is a modified and relaxed version of the old discount window borrowing, this time designed for primary dealers. On March 17, 2008, the Federal Reserve started lending through the PDCF, which allows the primary dealers to borrow at the Fed's discount window using several forms of collateral, including mortgage-backed securities.

Basically, a PDCF loan is an overnight repurchase agreement, or "repo," where a primary dealer sells its (potentially risky) security to the Fed and agrees to buy it back at a later date (generally the next day) at a higher price that includes interest. According to the Fed’s description, “the rate paid on the loan will be the same as the primary credit rate at the Federal Reserve Bank of New York,” which is “currently 25 basis points above the target federal funds rate.” “In addition, primary dealers will be subject to a frequency-based fee after they exceed 30 days of use within the first 120 business days of the program. The frequency-based fee will be based on an escalating scale and communicated to the primary dealers in advance.”

Now again comes the interesting part: “Eligible collateral will include all collateral eligible for tri-party repurchase agreements arranged by the Federal Reserve Open Market Trading Desk, as well as all investment-grade corporate securities, municipal securities, mortgage-backed securities, and asset-backed securities for which a price is available.” Wow. It means that basically whenever debt is priced (i.e., the already infamous "marked-to-model" pricing can be applied here) and is conveniently investment-grade-rated (by the way, rated by the agencies, which are not really independent from the banks), it can be used as collateral by a primary dealer to borrow money from the Fed. Here we are not even talking about AAA/Aaa-rated debt - the definition of allowed collateral extends to include all debt rated as low as BBB/Baa. Given the quality of credit ratings that the leading credit agencies have provided so far, I am very skeptical about the quality of debt that will be included as collateral under the PDCF program. Aside: I use credit-rating software programs regularly at work and can honestly say that the existing valuation approaches used by Moody’s and Standard & Poor’s are very weak and do not properly capture certain risks.

The PDCF lending program provides overnight loans with daily settlement, which can be re-borrowed (rolled over) each day up to a period of six months and which can be extended even further as the Fed’s vague terms indicate: “…longer if conditions warrant” – whatever it is supposed to mean. It is different from regular discount-window borrowing in several aspects. First, it is available to primary market dealers, not depositary institutions. Second, it has a longer term of funding, which is 120+ days versus only 90 days under regular discount-window borrowing. Third, the range of collateral permissible under PDCF lending is much broader and includes all kinds of investment-grade-rated government and private debt.

4. Summary

Summarizing the differences among the three facilities:

  1. TAF: Open to depository institutions, cash is borrowed, the total monthly facility limit is $100 billion, fixed lending amounts, fixed interest is determined via bi-weekly closed-bid auctions, lending term of 28 days, collateral is similar to collateral for discount window borrowing and presently includes Treasuries and AAA-rated government agency debt. (The collateral requirement will probably be further relaxed by the Fed??)

  2. TSLF: Open to primary dealers only, U.S. treasuries are borrowed, the total monthly facility limit is $200 billion, fixed lending amounts, interest is determined via weekly auctions, lending term of 28 days, collateral includes AAA/Aaa-rated government-agency and private debt including mortgage-based securities.

  3. PDCF: Open to primary dealers only, cash is borrowed, the total monthly facility limit is ???, flexible lending amounts, the borrowing rate is given by the current discount rate, term is overnight with a rollover option of up to 120 days, collateral includes investment-grade-rated (AAA/Aaa-BBB/Baa) government-agency and private debt including mortgage-based securities.

What can be said at the end about these Fed's innovations? I have several things to comment on:

First, I have a feeling that we will see the other similar creatures of the Fed during the upcoming months, as it tries to provide troubled banks and securities firms with crucially needed financing. Alternatively, the presently set credit limits on the existing facilities will be extended further because the current terms and conditions on the Fed's facility programs are open to such future upward revisions.

Second, I do not really believe in the short-term nature of these facility programs. Overnight or 28 days or six months, whatever - these loans will be rolled over multiple times until the bankers are able to fix their issues. The Fed will let them do it because it will take time (up to several years) to completely remove or restucture the unperforming instruments from the banks' books.

Third, I do not think that submitting auction bids over the phone to local Fed Reserve Banks is the most effective and transparent form of bidding for funds. Well, if we assume that the true intention is NOT to get the highest price for borrowed funds, then it is understandable, but otherwise this phone-hotline bidding procedure is very prone to manipulations and inefficient pricing.

Fourth, I think these programs represent the unprecedented misuse and abuse of the U.S. monetary system. Thanks to the Fed's facility arrangements, the social parasites from the financial services sector can now more easily borrow public funds to cover up and patch the consequences of their numerous misdeeds. To make the matters worse, the Fed does not provide a complete and prompt disclosure under any of the three facility programs on what banks borrow what amounts, on what specific terms, and in return for what collateral. Such a lack of transparency is clearly disturbing.

Fifth, the easy money that the banks will receive from the facility loans will flood the U.S. economy almost immediately and will create inflation, nothing more. Most of this money will not be able to find productive projects that generate real economic growth because such productive opportunities either do not exist in the present conditions or because the bankers will waste them as they are wasting billions of dollars each year on ephemeral create-a-bubble-and-grab-a-quick-profit-before-it-is-too-late schemes. What is the solution to the present situation that the Fed and the bankers are likely to pursue from now on? More likely, making another bubble, even bigger than those we have seen before. Do not be surprised if you see a new story filling up the headlines starting in 2008 and 2009 - say, the Alternative Energies Dream. Just be cautious and remember that it will only last a few years before we have an even worse lending.

Sixth, I believe that the introduction of these facilities is yet another significant step towards trashing the U.S. monetary system and the value of the U.S. dollar. The U.S. currency has not been backed up by gold or anything of real value since 1972 when the international Gold Standard system was killed. The only things that kept the U.S. dollar afloat were: reputation of the U.S. government and its debt, the crucial functional role as the world’s reserve and international settlements currency, and the size and global importance of the U.S. economy. None of these factors are strong (I would even say “present”) any more. Up until now, the U.S. Federal Reserve was backing up the value of the U.S. dollar with U.S. government debt, which has been ballooning in size at the geometrical growth rate yet was still considered as one of the safest top-rated debt securities around the globe. With the new lending practices, the Fed will stain its balance sheet with intrinsically junky asset-backed government agency and private debt instruments, which in my honest opinion do not have much real value in comparison with their original “market-based” valuations.

Since we have trillions of such securities issued and outstanding, it is clear where we are going in the case the Fed will have to step in and buy most of this junk. Newly minted paper notes named US dollars will not be worth much if the panic in the U.S. banking sector spreads and detonates the credit derivatives markets, which has grown to humongous proportions lately and will have a devastating effect on all other sectors of the economy on the case of the negative chain reaction. Even if the crisis is avoided this time and the financial system does not collapse, the consequences of having intrinsically worthless private instruments on the financial statements of the monetary-authority institution placed in charge of monetary policy of a large sovereign country will not be positive for the U.S. dollar and the U.S. economy in the longer term.

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