A few spoonfuls of potent medicine by the Federal Reserve

In its bid to overcome growing recession and liquidity fears, the Fed had earlier announced that it would add further liquidity to money markets by raising the size of the Term Auction Facility (TAF) auctions to be held on March 10th and 24th to USD 50 bn each, an increase of USD 20 bn from the amounts that were announced on Feb 29. Fed officials also announced that it would initiate a series of 28-day term repurchase transactions that are expected "to cumulate to USD 100 bn" and increase the auction sizes further in future if conditions warrant. Yesterday, the Fed in coordination with four other Central Banks (BoE, SNB, BoC and ECB) stepped up its efforts to assuage the growing strains in global credit markets by significantly extending dollar loans to banks in their respective nations. The Fed supplemented its previous TAF and repo initiative with the Term Security Lending Facility (TSLF) thereby expanding its low securities lending program to enable bond dealers to borrow up to USD 200 bn of Treasury securities, collateralized by other securities, including Fannie and Freddie Mac backed bonds, Fannie and Freddie Mac backed MBS and other AAA rated MBS. Furthermore, the Fed also raised the size of its "swap" agreements with the European Central Bank (ECB) to USD 30 bn from USD 10 bn previously, and with the Swiss National Bank (SNB) to USD 6 bn from USD 2 bn previously. With many banks in the EU facing huge dollar loan obligations while being exposed to risk of US mortgage loans, the swap agreements would enable the respective Central Banks to borrow dollars from the Fed and lend the same to their own banks, thereby alleviating the funding pressures in these markets.

March 10th TAF Auction suggests increased demand for funds:

The result of the March 10th TAF auction suggests that funding pressures continue to exist amongst US banks despite substantial liquidity injection by the Fed through previous TAF auctions in addition to the discount window borrowing as well as open market operations. Until January, it seemed that the Fed had done considerably well in managing market liquidity and eased liquidity concerns in the short term money markets. This is evident from the table above, which depicts a significant drop in bid/cover ratio ( 1.25 in Jan 28th from 3.08 in December 17th) as well as total propositions submitted (USD 37.45 bn from USD 61.553 bn in December 17). However, credit conditions deteriorated markedly over the past two months as the contagion spread beyond the realms of subprime mortgage onto much safer Alt A and even prime mortgages to some extent, thereby hitting major banks, bond insurers, mortgage insurers, hedge funds among others. The latest TAF auction reflected heightened demand for funds with the number of bidders increasing to 82 from 72 previously while total propositions rose to USD 92.595 bn from USD 50 bn previously.

How is TAF different from TSLF?

The Fed has established the Term Auction Facility (TAF) program in order to auctions funds to depository institutions of approximately one-month maturity. The TAF is essentially a collateralized credit facility that allows all those depository institutions that are eligible under the Discount Window Facility, to bid for an advance from its local Federal Reserve Bank at a rate that is Auction determined. The collateral that is eligible to be pledged remains the same as under the Discount Window facility, which includes U.S. Treasury securities, State and local government securities, Collateralized mortgage obligations (AAA rated), and Investment-grade certificates of deposit.Under the Term Securities Lending Facility (TSLF) the Fed auctions U.S. Treasury securities, which includes Treasury bills, note and inflation indexed securities against AAA/Aaa-rated Residential Mortgage backed securities not on review for downgrade along with bonds and MBS which are backed by Fannie and Freddie Mac. The TSLF essentially extends the Fed's low-profile Securities Open Market Account (SOMA) lending program enabling banks to pledge a wider range of collaterals for a longer period of up to 28 days at a time rather than overnight, as was the case with SOMA.

Would TSLF serve its purpose?

Global financial markets have hauled the Central Bank's coordinated actions with the Dow climbing 3.5% yesterday while the S&P 500 gaining 3.71% yesterday. Conditions in the short term money markets eased considerably following Fed's initiatives to address hightenened liquidity pressures coupled with an assurance " to conduct TAF auctions for at least the next six months unless evolving market conditions clearly indicate that such auctions are no longer necessary," The 3M USD LIBOR dipped further below the current fed funds target rate to 2.8675% from 2.938 bps last week while the 6M USD LIBOR touched a low of 2.74% from 2.86% last week. The TSLF provides an important outlet for stained MBS, thereby comforting dealers who were stuck with the soured paper after being dumped by investors facing margin calls. The move would also help partially mitigate the investor nervousness over financial condition of GSEs Fannie Mae and Freddie Mac, who had posted huge fourth quarter losses amidst rising delinquencies. However, there is a high risk that TSLF may prove to be a short term analgesic as the securities lending facility is a temporary transaction with the MBS returning to bank balance sheets after maturity. Also, with the ball now in the Fed's court, the Fed's own balance sheet looks much riskier thanks to the increased share of the risky MBS instead of the safe treasuries. The Fed, which would need to cushion these risky securities with extra collateral and guarantees, seems confident that the TSLF would play an important role in promoting liquidity in the financial markets for treasury and other collateral and thus foster the functioning of financial markets more generally.