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     Apr 2, 2008
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A panic-stricken Federal Reserve
By Henry C K Liu

(Part 1: A rich free-market legacy - for some)
(Part 2: Long-term effects of the Civil War)
(Part 3: The progressive era)

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?

Continued 1 2 3 4 5 

The Complete Henry C K Liu

1. The mustard seed in global strategy

2. The day the US declared war on Iran

3. Turn it into a theme park ...

4. Kids go to gold camp

5. FDR's dream comes true as nightmare

6. Pakistan in tug of war over terror

7. Russia chalenges US in the Islamic world

8. Tibet, the 'great game' and the CIA

9. Shi'ite fight shows other side of the COIN

10. A sheikha, a queen and a first lady

(24 hours to 11:59 pm ET, Mar 31, 2008)



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