The recent moves by the US Federal Reserve
in the months following the credit market seizure
of August 2007 to inject liquidity into a failed
credit market and to bail out distressed banks and
brokerage houses that had been caught holding
securities of dubious market value are looking
more like fixes for drug addicts in advanced
stages of abuse.
So far, many of the Fed's
actions taken to deal with the credit crisis have
been self neutralizing, such as pushing down
short-term interest rates to try to save wayward
institutions addicted to
fantastic returns from
highly leveraged speculation, only to cause the
dollar to free fall, thus causing dollar interest
rates and commodity prices, including food and
energy, to rise.
First, four months after
the August 2007 credit market seizure, the Fed
announced on December 12 the Term Auction Facility
(TAF) program, under which the Fed will auction
term funds to depository institutions against the
wide variety of collateral that can be used to
secure loans at the discount window. By allowing
the Fed to inject term funds through a broader
range of counterparties and against a broader
range of collateral than open market operations,
this facility was intended to help promote the
efficient dissemination of liquidity when the
unsecured interbank markets came under stress.
Each TAF auction was to be for a fixed
amount, with the rate determined by the auction
process subject to a minimum bid rate. The first
TAF auction of US$20 billion was scheduled for
December 17, with settlement on December 20; this
auction provided 28-day term funds, maturing
January 17, 2008. The second auction of up to $20
billion was scheduled for December 20, with
settlement on December 27; this auction provided
35-day funds, maturing January 31, 2008. The third
and fourth auctions were held on Mondays, January
14 and 28, with settlement on the following
Thursdays. The amounts of those auctions were
determined in January. The Fed would conduct
additional auctions in subsequent months,
depending in part on evolving market conditions.
Experience gained under this temporary
program was expected to be helpful in assessing
the potential usefulness of augmenting the Fed's
current monetary policy tools - open market
operations and the primary credit facility - with
a permanent facility for auctioning term discount
window credit. The board anticipated that it would
seek public comment on any proposal for a
permanent term auction facility. In other words,
the Fed had no idea how the market would react to
its TAF program.
At the same time, the Fed
Open Market Committee (FOMC) authorized temporary
reciprocal currency arrangements (swap lines) with
the European Central Bank (ECB) and the Swiss
National Bank (SNB). These arrangements provided
dollars in amounts of up to $20 billion and $4
billion to the ECB and the SNB, respectively, for
use in their jurisdictions. The FOMC approved
these swap lines for a period of up to six months.
On December 21, 2007, the Fed announced
its intention to conduct biweekly TAF auctions for
as long as necessary to address elevated pressures
in short-term funding markets. The Board of
Governors was to announce the sizes of the January
14 and January 28 TAF auctions at noon on January
4.
On January 4, 2008, the Fed announced
it would conduct two auctions of 28-day credit
through its TAF in January, increasing to $30
billion the auction to be held on January 14 and
$30 billion in the auction to be held on January
28.
On February 1, 2008, the Fed announced
it would conduct two auctions of 28-day credit
through its TAF in February, offering $30 billion
in an auction to be held on February 11 and $30
billion again in an auction to be held on February
25, making the total in February $60 billion. To
facilitate participation by smaller institutions,
the minimum bid size was to be reduced to $5
million, from $10 million in the previous auctions
On February 29, 2008, the Fed announced it
would conduct two auctions of 28-day credit
through its TAF in March. It would offer $30
billion in an auction to be held on March 10 and
$30 billion in an auction to be held on March 24,
making the total for March $60 billion.
But on March 7, 2008, the Fed announced
two new initiatives to address continuing
heightened liquidity pressures in term funding
markets. First, the amounts outstanding in the TAF
were to be increased to $100 billion from $30
billion. The auctions on March 10 and March 24
each would be increased to $50 billion - an
increase of $20 billion from the amounts that were
announced for these auctions on February 29. The
Fed would increase these auction sizes further if
conditions warrant.
To provide increased
certainty to market participants, the Fed would
continue 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 Fed was acknowledging that the
credit market crisis was not a passing storm and
that its previous TAF auctions did not produce the
intended effect in the market.
Second,
beginning immediately, the Fed initiated a series
of term repurchase transactions that were expected
to cumulate to $100 billion. These transactions
would be conducted as 28-day term repurchase
(repo) agreements in which primary dealers might
elect to deliver as collateral any of the types of
securities - Treasury, agency debt, or agency
mortgage-backed securities - that are eligible as
collateral in conventional open market operations.
As with the TAF auction sizes, the Fed would
further increase the sizes of these term repo
operations if future conditions should warrant.
The Fed announced that it was in close
consultation with foreign central bank
counterparts concerning liquidity conditions in
markets. (See The Repo Time Bomb, Asia
Times Online, September 29, 2005.)
On
March 20, Bloomberg.com ran a report by Liz Capo
McCormick - Treasuries' Scarcity Triggers Repo
Market Failures:
Surging demand for US Treasuries is
causing failures to deliver or receive
government debt in the $6.3 trillion a day
market for borrowing and lending to climb to the
highest level in almost four years. Failures, an
indication of scarcity, surged to $1.795
trillion in the week ended March 5, the highest
since May 2004, and up from $374 billion the
prior week. They have averaged $493.4 billion a
week this year, compared with $359.6 billion
over the last five years and $168.8 billion back
through July 1990, according to data from the
New York Fed.
Investors seeking the
safety of government debt amid the loss of
confidence in credit markets pushed rates on
three-month bills today to 0.387%, the lowest
level since 1954. Institutions worldwide have
reported $195 billion in writedowns and losses
related to subprime mortgages and collateralized
debt obligations since the start of 2007, making
firms reluctant to hold anything but Treasuries
as collateral on loans.
"It shows you
the kind of anxieties that are going on and the
keen demand for Treasuries," said Tony
Crescenzi, chief bond market strategist at
Miller Tabak & Co in New York. "The rise in
fails tells us about the inability of dealers to
obtain Treasury collateral." In a repurchase
agreement, or repo, a customer provides cash to
a dealer in exchange for a bill, note or bond.
The exchange is reversed the next day, with the
customer receiving interest on the overnight
loan. A Treasury security is termed on 'special'
when it is in such demand that owners can borrow
cash against it at interest rates lower than the
general collateral rate.
The Treasury
Department cautioned dealers in January to guard
against failing to settle in the Treasury repo
market as interest rates fall. It cited periods
of such failures to receive or deliver
securities, known as "fails" in the repo market,
earlier in the decade when rates dropped.
The difference between the rate for
borrowing and lending non-specific Treasury
securities, or the general collateral rate, has
averaged 63 basis points below the central
bank's target rate for overnight loans this
year. The spread has averaged about 8 basis
points the past 10 years.
Overnight
general collateral repo rates have traded lower
than the Fed's target rate for overnight lending
every day this year. The rate on general
collateral repo closed today [March 20] at 0.9%,
according to data from GovPX Inc, a unit of ICAP
Plc, the world's largest inter-dealer broker,
compared with 1.25% yesterday. Today's rate is
135 basis points below the Fed's target rate for
overnight lending of 2.25%. A spokesman for the
New York Fed declined to comment on the fails
data.
Nakedcapitalism.com observes
that a lot of Treasuries are now held by
counterparty risk-averse investors who are not
interested in lending them, which could complicate
the operation of the Fed's new facilities designed
to unfreeze the mortgage market. The Fed may be
running into its own liquidity constraints as it
depletes its Treasury holdings and cannot add more
non-inflationary "sterilized" liquidity.
The scarcity of Treasuries for repos means
that demand for repo collaterals will push up
Treasury prices and push down yields. Three month
Treasury bills traded at 0.56% on March 19, a
50-year low, and a stunning 0.39% the following
day, a rate last seen in 1954. Since bill prices
are used as the input into other pricing models
(most notably the widely used Black-Scholes option
pricing model), the distortions in the Treasure
market have the potential to feed into other
markets, such as the credit default swaps market.
On March 11, 2008, the Fed announced that
since the coordinated actions taken in December
2007, the G-10 central banks had continued to work
together closely and to consult regularly on
liquidity pressures in funding markets. Pressures
in some of these markets had recently increased
again. "We all continue to work together and will
take appropriate steps to address those liquidity
pressures. To that end, today the Bank of Canada,
the Bank of England, the European Central Bank,
the Federal Reserve, and the Swiss National Bank
are announcing specific measures."
On the
same day, the Fed announced an expansion of its
securities lending program to include a new Term
Securities Lending Facility (TSLF), under which
the Fed would lend up to $200 billion of Treasury
securities to primary dealers secured for a term
of 28 days (rather than overnight, as in the
existing lending program) by a pledge of other
securities, including federal agency debt, federal
agency residential-mortgage-backed securities
(MBS), and non-agency AAA/Aaa-rated private-label
residential MBS. The TSLF 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.
In addition, the Federal Open Market
Committee has authorized increases in its existing
temporary reciprocal currency arrangements (swap
lines) with the European Central Bank (ECB) and
the Swiss National Bank (SNB). These arrangements
will now provide dollars in amounts of up to $30
billion and $6 billion to the ECB and the SNB,
respectively, representing increases of $10
billion and $2 billion. The FOMC extended the term
of these swap lines through September 30, 2008.
The actions announced would supplement the
measures announced by the Federal Reserve on March
7 to boost the size of the Term Auction Facility
to $100 billion and to undertake a series of term
repurchase transactions that will cumulate to $100
billion.
This program allows primary
dealers to exchange a total of $200 billion MBS of
uncertain market value for Treasuries for 28 days
instead of the traditional overnight lending. Why
$200 billion?
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