During the
financial crisis that started in late 2007, the US
Federal Reserve resorted to extraordinary
meta-monetary measures. On March 11, 2008, the Fed
announced an expansion of its securities lending
program and arranged the Term Security Lending
Facility (TSLF) to provide secured loans
collateralized with Treasury securities to the 18
primary dealers for 28-day terms.
On the
same day, the Federal Open Market Committee (FOMC)
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 would
now provide dollars in
amounts of up to US$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
Under this new TSLF,
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 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 was intended to promote liquidity in
the financing markets for Treasury and other
collateral and thus to foster the functioning of
financial markets more generally. As was the case
with the then current securities lending program,
securities would be made available through an
auction process. Auctions were held on a weekly
basis, beginning on March 27, 2008. The Fed
consulted with primary dealers on technical design
features of the TSLF to fit their funding needs.
TSLF was a weekly loan facility that
promoted liquidity in Treasury and other
supposedly high-rated collateral markets and thus
fostered the functioning of financial markets more
generally. The program offered Treasury securities
held by the System Open Market Account (SOMA) for
loan over a one-month term against other
program-eligible general collateral.
Yet
the qualifying credit ratings of the acceptable
collaterals were mostly based on mark-to-model,
since primary dealers holding of high-rated
collaterals mark-to-market had no need to borrow
from TSLF. Securities loans were awarded to
primary dealers based on a competitive
single-price auction. Obviously, primary dealers
in deepest stress would bid the highest
single-price for loans.
The first TSLF
auction was conducted on March 27, 2008. The TSLF
was closed almost two years later on February 1,
2010, but the Fed said it may resume if market
conditions warrant. By market conditions, the Fed
meant when a gap again develops between
mark-to-market values and mark-to-model values
that creates distress for primary dealers. Thus
TSLF was really a facility to support primary
dealers on more than liquidity distress.
The SOMA Securities Lending program offers
specific Treasury securities held by SOMA for loan
against Treasury GC (general collateral repos) on
an overnight basis. Dealers bid competitively in a
multiple-price auction held every day at noon. The
TSLF would offer Treasury GC held by SOMA for a
28-day term. Dealers would bid competitively in
single-price auctions held weekly and borrowers
would pledge program-eligible collateral.
In contrast to the Term Auction Facility
(TAF), which offered term funding to depository
institutions via a bi-weekly competitive auction,
the TSLF offered Treasury GC to the New York Fed's
primary dealers in exchange for other
program-eligible collateral. The New York Fed term
repo operations are designed to temporarily add
reserves to the banking system via term repos with
the primary dealers. These agreements are
cash-for-bond agreements and have an impact on the
aggregate level of reserves available in the
banking system. The security-for-security lending
of the TSLF, however, would have no impact on
reserve levels since the loans were collateralized
with other securities.
Primary Dealer
Credit Facility On March 16, 2008,
invoking authority under the rarely used Section
13(3) of the 1932 Federal Reserve Act, the Fed
established temporarily the Primary Dealer Credit
Facility (PDCF) to provide allegedly fully secured
overnight loans to primary dealers. Primary
dealers are banks and securities brokerages that
trade in US government securities with the Federal
Reserve System. As of September 2008, there were
19 primary dealers. Daily average trading volume
in US government securities by primary dealers was
approximately $570 billion during 2007. PDCF was
an overnight loan facility that provided funding
to primary dealers in exchange for any
tri-party-eligible collateral and was intended to
foster the functioning of financial markets more
generally.
PDCF differed from other Fed
facilities in the following ways. The Term Auction
Facility program offered term funding to
depository institutions via a bi-weekly auction,
for fixed amounts of credit. The Term Securities
Lending Facility was an auction for a fixed amount
of lending of Treasury general collateral in
exchange for open market operations (OMO)-eligible
and investment grade (AAA) corporate securities,
municipal securities, mortgage-backed securities,
and asset-backed securities.
Fed credit
advanced to the primary dealers under the PDCF
increased the total amount of bank reserves in the
financial system, in much the same way that
discount window loans do. To offset this increase,
the OMO desk utilized a number of tools,
including, but not necessarily limited to,
outright sales of Treasury securities, reverse
repurchase agreements (reverse repos), redemptions
of Treasury securities and changes in the sizes of
conventional reverse repo transactions.
But PDCF credit differed from discount
window lending to depository institutions in a
number of ways. The discount window primary credit
facility offers overnight as well as term funding
for up to 90 calendar days at the primary credit
rate secured by discount window collateral to
eligible depository institutions. The primary
credit facility at the discount window, as revised
by the Federal Reserve in 2003, offered credit to
financially sound banks at a rate 100 basis points
above the Federal Open Market Committee's target
federal funds rate (the primary credit rate).
Primary credit was made available to
depository institutions at an above-market rate
but with very few administrative restrictions and
no limits on the use of proceeds. Because the
interest rate charged on primary credit was above
the market price of funds, it replaced the
rationing mechanism for obtaining funds from the
central bank and eliminated the need for
administrative review by the Federal Reserve.
Amid the onset of the liquidity crisis in
August 2007, the Federal Reserve lowered the
spread between the primary credit rate and the
target funds rate from 100 basis points to 50
basis points and extended the maximum term of
loans to 30 days.
In March 2008, the Fed
once again narrowed the spread, this time to 25
basis points, and extended the loan term to 90
days. The moves were motivated by the desire to
make discount window credit more accessible to
depository institutions.
The Fed's actions
led to an increase in the volume of discount
window borrowing during the crisis. While the
massive increase in the volume of borrowing
supports the argument that the stigma of borrowing
had been eliminated, one should be cautious when
interpreting this result. Despite the expansion in
borrowing, some trades in the funds market took
place at rates above the primary credit rate.
Reluctance of banks to borrow from the Fed
discount window has several components. The
non-price mechanism is the component attributable
to the Fed's implementation of discount lending.
This component declined significantly after the
establishment of the revised facility in 2003.
Meanwhile, a second type of stigma arises
from the asymmetric information problems
associated with discount window borrowing.
Specifically, while most banks borrow from the
discount window, the facility is also used by
troubled or failing institutions. Because market
participants cannot fully differentiate sound from
troubled borrowers, they may view borrowing as a
potential sign of weakness of any bank that visits
the discount window. If this type of stigma
increases at the early stages of a financial
crisis, when institutions are trying to signal
their good health, it could explain the spikes in
the funds rate over the primary credit rate. In
addition, it is plausible that the capital crunch
during the financial crisis left some institutions
without sufficient collateral to apply for primary
credit loans and thus forced them to bid for
higher rates in the federal funds market, which is
un-securitized.
The PDCF, by contrast, was
an overnight facility available to primary dealers
(rather than depository institutions). PDCF
expired on February 1, 2010.
Since not all
primary dealers are depository institutions, the
Fed, to provide credit assistance to them, had to
invoke authority under Section 13(3) of the 1932
Federal Reserve Act, as amended by the Banking Act
of 1935 and the FDIC Improvement Act of 1991,
which permits the Fed to lend to any individual,
partnership, or corporation "in unusual and
exigent circumstances if the borrower is "unable
to secure adequate credit accommodations from
other banking institutions".
Section 13(3)
was enacted in 1932 out of concern that widespread
bank failures would make it impossible for many
firms to obtain loans, thus depressing the
economy. In the four years after the section was
added, the Fed made a total of 123 loans totaling
just $1.5 million. Section 13 (3) was not used
again until 2008, 76 years later.
In
addition to applying Section 13(3) to PDCF, the
Fed also invoked it to authorize the New York Fed
to lend $29 billion to a newly created special
limited liability corporation named Maiden Lane,
LLC, to exclusively facilitate the
Fed/Treasury-sponsored JPMorgan Chase acquisition
of Bear Stearns, which faced imminent insolvency
from bad investments in subprime mortgage
securities extensively funded by overnight repos
that were unable to rollover.
The PDCF and
the Maiden Lane loan departed significantly from
the Fed's normal practice of lending only to
financial sound institutions against top-rated
collaterals. The departure was again made when the
NY Fed was granted authority to lend to mortgage
guarantors Fannie Mae and Freddie Mac to
supplement the Treasury's moves to stabilize these
government-sponsored enterprises (GSEs). As it
turned out, the Treasury had to place both GSEs
under conservatorship in September 2008.
Nevertheless, a brave new world of central
banking began with these new authorities by the
Fed to make unconventional loans against toxic
assets. Besides TARP programs, mortgage financiers
Fannie Mae and Freddie Mac have received more than
$125 billion in federal aid. There is no
indication that either firm will be able to repay
the government anytime soon, if ever.
In
March 2008, JPMorgan Chase had been provided with
a $29 billion credit line from the Fed discount
window in its purchase of Bear Stearns arranged by
the Treasury. In early September, the Treasury
seized control of Fannie Mae and Freddie Mac with
a $200 billion capital injection against a $4.5
trillion liability, concurrent with another
government arranged "shotgun marriage" that
induced Bank of America to acquire Merrill Lynch
at a fire sale price of $50 billion.
The
Henry Paulson-led Treasury had been criticized and
had become sensitive to criticism of bailing out
private Wall Street firms that should have been
allowed to fail from irresponsible market
misjudgments, and Treasury secretary Paulson was
eager to show that going forward it was not
government policy to increase moral hazard.
Lehman bankruptcy Lehman
Brothers' bankruptcy filing on September 15, 2008,
was the result of failure of the coordinated
efforts by the Ben Bernanke Fed and the Paulson
Treasury to find a qualified buyer for the failing
firm. At the end, the refusal of the Bank of
England to approve the participation of Barclays
was a bridge too far in a desperate campaign to
save Lehman. Secretary Paulson, sensitive to
criticism that he helped to distort markets by
bailing out Merrill Lynch, resisted pressure to
rescue Lehman. Alan Meltzer, professor of
political economy at Carnegie Mellon University
and the respected author of A History of the
Federal Reserve, argued that allowing Lehman
to fail was "a major error that deepened and
lengthen the current recession".
Fed
chairman Bernanke, while defending the Fed's
inaction by citing a technical legal restraint on
Fed lending without adequate collateral, which
Lehman did not have in relation to its funding
needs, admitted on public television afterwards
that "Lehman proved that you cannot let a large
internationally active firm fail in the middle of
a financial crisis".
He might as well have
added you also cannot bailout a large
internationally active firm without long-term
effects on market operations with penalties for
the economy. By now, it is becoming clear that the
difference between government bailouts and
no-bailouts is not different levels of economic
pain, but how the pain will be borne over time and
by whom - those who were responsible for the
crisis, or innocent taxpayers. Once those
responsible for the crisis are allowed to escape
with no penalty, no reform can prevent replays of
the crisis.
Within hours of the Lehman
bankruptcy filing, the Fed was confronted with the
imminent failure of the American International
Group (AIG) from exposure to the failure of the
subprime mortgage market through its underwriting
of credit default swaps insurance and other
derivative contracts and portfolio holdings of
mortgage-backed securities. All concerns of moral
hazard went out the window as the Fed and Treasury
panicked and opened the door to save dysfunctional
market capitalism by replacing it with state
capitalism. The pain was relieved by putting the
patient in a coma.
AIG
bailout Determining that AIG was too big to
fail, the Federal Reserve Board on September 16
announced that "in current circumstances, a
disorderly failure of AIG could add to already
significant levels of financial market fragility
and lead to substantially higher borrowing costs,
reduced household wealth and materially weaker
economic performance", to justify invoking Section
13(3) of the Federal Reserve Act to make an $85
billion loan to AIG, secured by the assets of AIG
and its subsidiaries.
In the course of two
days, the Fed took different approaches in dealing
with imminent failure of two major institutions,
neither of which was a depository institution and
therefore not qualified for funding support
through the Fed's normal lending programs.
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