Last week the Fed announced yet another new measure to deal with the ongoing problems in credit markets in the form of a just-created
Term Securities Lending Facility, which we’re apparently invited to refer to affectionately as a TSLF.
Hear the word of the Fed:
Under this new Term Securities Lending Facility (TSLF), the Federal Reserve will 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 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.
This is the logical next step in Bernanke’s vision of monetary policy using the asset side of the Fed’s balance sheet. This strategy shift began last September, when the Fed was simultaneously implementing two kinds of operations. On the one hand, the Fed was conducting repurchase agreements, in which it takes temporary possession of certain private sector assets (including possibly mortgage-backed securities) and gives cash to the recipient by creating new Federal Reserve deposits. Essentially a repo is a short-term collateralized loan from the Fed. On the other hand, the Fed was simultaneously conducting open market sales out of the Fed’s holdings of Treasury securities (or allowing existing holdings to expire through redemption), either of which by itself would absorb Federal Reserve deposits . The combined effect of the dual operations was to leave the Fed’s total assets (and therefore its total liabilities) unaffected. Since there was no change in total liabilities, it had no direct implications for the total volume of Federal Reserve deposits or the money supply, which is how we usually think of monetary policy affecting the economy. But by reducing the Fed’s holdings of Treasuries and increasing the Fed’s holdings of the procured collateral, the swap allowed banks temporarily to replace problem assets with good funds, at least for the term of the repo.
|Dec 20||Jan 17||20||20|
|Dec 27||Jan 31||20||40|
|Jan 17||Feb 14||30||50|
|Jan 31||Feb 28||30||60|
|Feb 14||Mar 13||30||60|
|Feb 28||Mar 27||30||60|
|Mar 13||Apr 10||50||80|
In December, the Fed introduced the term auction facility as a device for implementing such swaps on a bigger scale. In these operations, banks could offer a variety of assets as collateral, and receive loans of Federal Reserve deposits. Again these operations were offset by open market sales of Treasuries so as to keep the total volume of Fed assets and liabilities unchanged. By my calculations, the Fed is currently holding $80 billion in assets under this facility, almost identical to the amount by which it has reduced its holdings of Treasury securities, and amounting to about 10% of its previous total Treasury holdings.
And the new TSLF will do the same thing on an even bigger scale– $200 billion has been announced as the first step. Under the TSLF, the Fed will temporarily swap more of its Treasury holdings for private sector troubled assets, and thereby eliminate the middle man required with repos or the TAF. No need to add reserves through the repo or TAF and then drain them out with open market sales. Instead we just swap the Treasuries directly for the target assets.
The Fed announced on Tuesday that it would increase its repos and TAF each to $100 billion, and the new TSLF is proposed as an additional separate $200 billion, which comes to a total of $400 billion, or about half of the quantity of Treasury securities that the Fed had been holding last summer.
What does the Fed hope to accomplish with all this? Steve Waldman draws a colorful analogy:
Until the current crisis is long past, I think it unlikely that any large bank will default and stiff the Fed with toxic collateral. Why not? Because for that to happen, the Fed would have to pull the trigger itself, by demanding payment on loans rather than offering to roll them over. Since TAF started last fall, on net, the Fed has not only rolled over its loans to the banking system, but has periodically increased banks’ line of credit as well. In an echo of the housing bubble, there’s no such thing as a bad loan as long as borrowers can always refinance to cover the last one.
The distinction between debt and equity is much murkier than many people like to believe. Arguably, debt whose timely repayment cannot be enforced should be viewed as equity. (Financial statement analysts perform this sort of reclassification all the time in order to try to tease the true condition of firms out of accounting statements.) If you think, as I do, that the Fed would not force repayment as long as doing so would create hardship for important borrowers, then perhaps these “term loans” are best viewed not as debt, but as very cheap preferred equity….
The Federal Reserve is injecting equity into failing banks while calling it debt. Citibank is paying 11% to Abu Dhabi for ADIA’s small preferred equity stake, while the US Fed gets under 3% now for the “collateralized 28-day loans” it makes to Citi…. I still think this all amounts to a gigantic bail-out.
Douglas Elmendorf defends the Fed from Waldman’s charge:
Taking agency MBS as collateral does not meaningfully increase the risk faced by the federal government. First, the Fed will presumably require a significant “haircut” on the value of the collateral. Second, if the federal government would ultimately prevent a default by Fannie and Freddie anyway, absorbing some of that commitment now does not add to the overall risk. Taking private MBS as collateral does increase risk, unless an adequate haircut is taken, because the government is otherwise unlikely to stand behind the truly private lenders.
Whether one takes comfort in Elmendorf’s argument depends entirely on the size of the haircut, about which I know only the following (from WSJ):
Fed officials decline to be specific except to say [the haircut] will seem conservative for ordinary times and liberal for tumultuous times. (One starting point may be the haircuts imposed on MBS collateral at the discount window: They range from 2% to 15% depending on the maturity and the availability of market pricing).
James Hymas is another defender of the Fed’s actions:
there are many players with indigestible lumps of sub-prime paper on their books. These are, I’ll bet a nickel, on their books at marked-to-disfunctional-market prices well below ultimate recovery, but so what? They can’t sell them to hot money– hot money’s got its own problems…. They can’t sell them to real money– real money read in the paper just last week that it’s all worthless junk. So the paper has to sit on the books for a while and be financed in the interim.
One measure economists sometimes use for the liquidity of an asset is the bid-ask spread. By that definition, one might be justified in referring to the present problems as a problem of liquidity– the gap between the price at which owners would like to sell these assets and the price that counterparties are willing to pay is so big that the assets don’t move. That illiquidity itself has proven to be a paralyzing force on the financial system. By creating a value for these assets– the ability to pledge them as collateral for purposes of temporarily acquiring good funds– the Fed is creating a market where none existed, thereby tackling the problem of liquidity head on.
OK, but if we agree to use that framework to describe the current difficulties as a liquidity (as opposed to a solvency) problem, which is closer to the “true” valuation, the bid or the ask price? If it’s not far from the asking price, then the Fed is taking a bold step that may help cure a profoundly serious problem. If it’s nearer the bid price, then the Fed has just agreed to absorb a huge chunk of what was formerly private-sector risk. To evaluate the magnitude of that risk absorption, we’d need to know the specific assets pledged as collateral, the specific terms, and the specific borrowers, none of which the Fed appears to have any intention of making public.
It appears to me that the Fed’s unconventional new measures surely involve at least some absorption of risk by the Federal Reserve itself. It therefore seems appropriate to try to think through the implications of what will happen if indeed the Fed is not repaid on some of these loans and gets stuck holding the inferior collateral.
It strikes me that the immediate accounting implications of such a default would be nil– the Fed now holds the collateral as an asset, can claim its value equals that of the original loan, and can carry it on that basis at least for several years, with no changes in its other assets or liabilities necessitated by the fact that the collateral is, in fact, not worth what it’s being carried at. The main cash flow implication that I can see is the following. When those Treasury securities were held by the Fed, the interest that the U.S. Treasury owed on the securities was a line entry for the U.S. Treasury (gross interest expense) that was exactly canceled by another entry (receipts returned from the Fed) to determine the “net interest” that the Treasury had to pay. With those Treasury securities now owned by the private sector instead of by the Fed, the Treasury’s going to have to make those payments with actual cash, and if the collateral is nonperforming, the Fed doesn’t have any receipts to return to the Treasury. The net cash flow consequences for the Treasury of a default would therefore be identical to those if the Treasury were simply to have borrowed up front a sum equal to the difference between the amount that the Fed lends and the amount that it is repaid.
In other words, the Fed seems to be committing the Treasury to cover any losses that may be incurred.
Even in the worst possible outcome, the ultimate increase in outstanding Treasury debt would be substantially less than $400 billion, because the collateral is far from worthless. And I would trust the Fed to be taking a smaller risk on behalf of the Treasury than I would expect to be associated, for example, with congressionally mandated expansion of FHA insurance, or the unclear implicit Treasury liability that results from increasing the assets and guarantees from Fannie or Freddie. Nevertheless, the doubters seem to me to be correct that the risks currently being absorbed by the Federal Reserve are substantially greater than zero.
You don’t get something for nothing.