Will a new, improved discount window solve our problems?
Yesterday, the Federal Reserve announced that it would (1) reduce its target for the fed funds rate by 25 basis points, lowering the target from 4.5% to 4.25%, and (2) reduce the interest rate it charges for borrowing from the Fed discount window by 25 basis points, lowering the latter rate from 5.0% to 4.75%. When I wrote that yesterday’s huge stock market decline was difficult to attribute to investors’ surprise about (1), several readers wanted to claim that, no, the real news was (2), in that many traders expected the Fed to cut the discount rate by more than it reduced the fed funds target.
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The graph above plots the total volume of borrowing from the Federal Reserve over the last year. Note well the scale– last week total borrowing came to 342 million dollars. To put this number in perspective, today the Federal Reserve injected $27.75 billion dollars in reserves in the form of traditional open market operations, a number that exceeds last week’s average daily borrowing by two orders of magnitude. Even the spike in borrowing in September only amounted to a little over $3 billion, still barely one-tenth the size of today’s open market operations. Twenty-five basis points on a billion dollars borrowed for 30 days comes to about $200,000. The claim that this could account for a 2.5% drop in the total value of the U.S. equity markets strikes me as, shall we say, creative.
But let’s hear the case, such as it is. WSJ Real-Time Economics quotes an analyst from the Bank of Nova Scotia as follows:
[The Fed] maintained the discount rate spread of [a half percentage point], which either indicates they don’t regard the strains in the money market as a significant risk, or that an aggressive reduction won’t do much good. Neither explanation does much for the market’s confidence, and it was no surprise to see equities tumble immediately after the announcement.
Well, unquestionably the Fed does see the strains in the money market as a significant risk. Evidently there are those who entertain the hope that the Fed could find two separate tools to achieve two separate ends. The first tool– the traditional instrument of monetary policy– is to adjust the total quantity of reserves available to the banking system so as to achieve a particular target value for the fed funds rate, the rate at which one bank lends to another overnight. When one describes a traditional monetary policy action as “providing liquidity,” this is what we are discussing.
But there appears to be a widespread belief that the Fed needs a second tool in order to achieve a second policy objective, which is somehow to eliminate the gridlock in financial institutions resulting from huge holdings of assets that no one seems willing to buy. Perhaps, the thinking seems to go, adjusting the spread between the discount rate and the fed funds rate could be a tool to accomplish this.
I am inferring that the Fed itself may also have been musing along these lines, in that it today announced creation of a term auction facility. The basic idea is that the Fed will specify a certain maximum amount that it would like banks to borrow. It intends to lend up to $20 billion for a 28-day term on Monday, and lend up to an additional $20 billion for a 35-day period on December 20. Potential borrowers will bid an interest rate to receive this loan, with I presume each $20 billion going to the highest bidders. Banks must also provide collateral for these loans.
The objective is clearly not just to get $40 billion more in reserves into the banking system next week– an open market operation could accomplish that just fine. The objective must be to get the reserves into the hands of those particular banks that want them most. Of course, those same banks could be getting them right now through the discount window, but choose not to, perhaps because of the stigma, or perhaps because of the financial penalty charged for discount borrowing relative to borrowing on the fed funds market from other banks. In effect, the term auction facility would reduce the spread between the discount rate and the fed funds rate to however low it needs to be in order to motivate $40 billion worth of borrowing next week.
The other thing the facility accomplishes is allow the Fed to accept lower-quality collateral from borrowers than its rules require for open market operations conducted through repurchase agreements. If there is an effect of the facility, I would think that this would be the mechanism. What may matter is not the reserves put in the system, nor who gets those reserves, but the troublesome assets temporarily taken off some institutions’ balance sheets.
We might then logically ask, what’s the source of the unwillingness of investors to purchase these CDOs and MBS? I would have thought that the answer has something to do with the market’s current evaluation of the risks. By agreeing to hold some of the problematic securities, the Fed is essentially offering to absorb some of that risk.
One might argue that in the best (and perhaps most likely) case, the Fed will suffer no loss, and possibly through its actions avert a very nasty cycle of bankruptcies and defaults. In the worst case, those defaults will come anyway, with the Fed absorbing some of the losses along with everybody else. But the way that the Fed would absorb these losses is by being forced to create more money. And, the argument might continue, if we had a financial crisis of the magnitude that produced a loss on the offered collateral, we’d be in a situation with a serious risk of deflation, precisely the circumstances in which we’d want some extra money creation. Win-win.
Or so the thinking may go. But I hope that Bernanke has also pondered the following– What would happen to foreign exchange markets and foreign demand for U.S. assets under the second happy scenario? There certainly is plenty of historical precedent for financial crises you can’t inflate your way out of– southeast Asia in 1997 comes to mind as one recent example.
Or if you’d like a second or third opinion, I recommend Felix Salmon, Steve Waldman (hat tip: Economists View), or [late update] Yves Smith and [later update] Accrued Interest. Greg Ip has some information that the Fed wanted to communicate to the public but apparently was unwilling to do so “on the record”. And doubtless you will soon be able to find any number of alternative perspectives from our readers in the comments section below.
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Thanks James for adding to my clarity on this new and creative (“Do they even know what they are doing?” I ask myself, used to ‘winging’ it.) move by the Fed to break the ice between those banks unwilling to lend to fellow suspects.
So far so good…about figuring out what the ‘new move’ might be…a thing in progress.
Cost of this service @ $40B/month for more than a few months? But at least the suspect “collateral” does get priced in the end? Does this action cultivate the next generation of “financial instruments”?
Does Citi’s deal with the Arabs then seem hasty? Is there a divide between Paulson/Treasury and the Fed/Bernanke on this solution?
Is there more or less consolidation as a result of this Fed intervention?
We might then logically ask, what’s the source of the unwillingness of investors to purchase these CDOs and MBS? I would have thought that the answer has something to do with the market’s current evaluation of the risks. By agreeing to hold some of the problematic securities, the Fed is essentially offering to absorb some of that risk.
Well, JDH, I can’t speak for “the market”, but I can speak for myself.
As a Canadian based fixed income specialist who’s been following all this, I can say I’m pretty sure there’s some good money to be made in that market. Unfortunately, I’m not sure whether there is sufficiently good, up-to-date information avialable on potential underlying securities to make it possible for a good analysis to be performed. I am, however sure of two other things: acquiring the expertise to make a diligent pronouncement on the value of a specific security relative to its price (even with all the information I could possibly want right in front of me) will take a long time, and I won’t be able to sell the idea to my clients anyway.
One method of choosing fixed income securities (while avoiding the investment of time necessary to become familiar with a new asset class or subclass) is to rely completely on the credit rating agencies for an assessment of credit quality and picking the highest yielding security from the dealers’ lists. This method is now viewed with disfavour.
I have heard that banks – and therefore, presumably, dealers – are getting awfully sticky about funding securities that can’t be presented at the discount window should the need arise. This will keep a lot of the hot money out of the game – they want to take on positions where they can make a big score, which means either leverage or an extremely liquid market they can enter and exit in a hurry.
In support of the funding argument, I can refer to CDS levels – it is my understanding that many CDSs are trading with a negative basis – that is, the spread to banks on the cash bond is greatly in excess of the premium on the CDS. With the WaMu basis at -167bp, for example, you could theoretically buy the cash bond, buy default protection from a large bank, and have, effectively, paper guaranteed by this large bank paying 167bp in excess of the large bank’s risk.
But funding is a problem (as well as counterparty risk). To make this interesting for the hedge funds, they want to lever up their position – but can’t get funding (or, if they can, can’t be sure the line won’t be pulled at an inconvenient time), and can’t be assured of unwinding their position when they want to.
The collective market (the banks themselves who should have the best risk evaluation tools) refuses to price these derivatives suggesting the very low quality of these instruments. This is the ultimate bailout and the average joe has to absorb it. The Fed clearly has chosen its path of inflating bad debts away.
The Fed’s “Surprise” Move
The Fed’s announcement of a term auction facility (TAF) caught the market by surprise this morning, despite the advance leak of likely moves which we reported yesterday. Those unwilling or unable to trade in the off-hours market missed the big
Izat so anony? China, holder of Trillions of $US tbills, is just going to sit on the sidelines and watch a bout of hyperinflation reduce those reserves to zero?
Why wouldn’t they have slashed more than the moderate amount they have if it’s as cut and dried as that? (calmo doesn’t know, he’s just poking)
The collective market –does that exclude or include the HFs associated with the banks who were reluctant to use the discount window …because it is damaging to their reputation? [What reputation was that again?]
I’m reading and listening so far. The market loved it initially but that waned from a hot response to something only slightly above cool, yes? Investors are glad about the gesture of a rescue represented by the intervention of the Fed and hope it works better than the short-lived Hope Now Gone intervention by the Treasury.
Glad to read the air of skepticism in your penultimate paragraph, Professor.
We’ll see how this plays out. Seems like near-desperation — called for, probably — but I do not like the idea of imprudent folks getting cash in exchange for near-worthless assets.
And, Ben, thanks for jacking up my gasoline costs again, today. Love that 11% YOY import price increase that you’ve given me, too.
One good thing to come of this mess is a better understanding of Fed operations. Conventional thinking says the Fed injects reserves to enable banks to make loans. Thus the money multiplier effect. In reality the Fed injects reserves so banks can meet reserve requirements. Banks make loans depending on loan demand and credit worthiness of borrowers. The Fed steps in after the fact to ensure sufficient reserves exist to meet demand. The conclusion is “loans create deposits” and the money multiplier is an “after the fact” result.
JDH – thanks. That’s very helpful. Consistent with my very inexpert and novice thinking in markets that I’d love to not worry about.
Mr. Hymas – likewise. A useful and informative expansion.
Would anyone/either/both of you care to walk thru the other instrument choices the Fed and the Central Banks are using to address this ?
And comment on whether this particular set of problems contagions over into debt instruments based on other asset classes ? Besides real estate I mean and aside from the comm. paper ripples. For example CLO’s etc. or even unto currency carry trades ?
If there was any doubt as to whether or not the Fed is totally lost and without a clue, this “answer” to Greg Ip’s query makes it clear that the Fed truly is winging it’s way through the graveyard:
“Answer: Officials said reducing or eliminating the spread between the discount and federal funds rate could have drawn an unlimited and unpredictable amount of borrowing, and caused banks to completely abandon the Federal funds market. That would cause the funds rate to plummet and make it hard for the New York Fed to get it close to the target rate chosen for monetary policy purposes. The auction mechanism gives the Fed more control over how much is lent out. Officials also couldnt be sure that narrowing or eliminating the discount rate penalty would have eliminated the stigma.”
So, the Fed believes that eliminating the spread between FF and the Discount Rate would either have led to a runaway avalanche of borrowing from the discount window that could have destroyed the FF market entirely, or else it would have had no effect at all (as has been the case thus far) because the stigma of borrowing from the window is so great. How’s that insight for narrowing down the range of possible outcomes? Good grief!!
AS the bloomberg.com article below suggests, I believe that Bernanke (quite mistakenly) believes that the Fed needs to separate the “burst of liquidity in a crisis” function of monetary policy from the long-term management of economic ggrowth and the price level function of monetary policy.
http://www.bloomberg.com/apps/news?pid=20601087&sid=au0j7cvkiVno&refer=home
That would explain some of the totally bizarre behavior and policies much better than any other speculation I’ve seen. However.
For one thing, this grand TAF doesn’t really add liquidity to the system, BECAUSE it’s a TERM facility. There’s few things worse than giving Wall Street a big refinancing date far in advance to worry about – that’s the problem with BIG BALLOON payments, the bill comes due all at once and the financial garbage term repo’d out in the TAF is going right back to the banks who’re choking on it now.
There’s NO WAY this bizarre strategy is going to provide ANY real help at all, because it doesn’t address the basic problem at all it’s just a band-aid solution to get us past the end of the year.
The basic problem is that there’s an enormous amount of garbage assets on the books of hyperleveraged institutions (those would be the big banks – with at best $1 of equity capital per $20 of assets) who cannot afford to write down the worst of their assets by the 50%-75% required to allow the market to clear – because that would take far too big a bite out of their regulatory capital and in this environment raising the large amount of new capital needed is almost impossible.
But the recent bad-asset puke that E-Trade did with Citadel is the way to clear the market — I think that mostly-garbage portfolio was sold to Citadel for 27 cents on the dollar. Citadel will do well on their investment and they can gradually trade out of much of the merchandise in a market that WILL clear because the assets are marked down so far that speculators (like Citadel) are interested in taking the risk.
They tried this kind of thing in Japan in the early nineties, problem was the cash just sat in the banks treasury depts reinvested in only the highest class securities as the velocity of money fell. The problem was that there were not enough credit worthy borrowers to lend to and in the end the government had to step in and effectively socialize credit. The Japanese could do this because a)They are a collectively minded bunch & b)They were running a huge trade surplus so all the funds were internal. In America this is not the case so I’m not sure how instructive this would be but it seems to me that the dollar could be in for a whole world of pain if the inflation route is taken. As an aside the last time PPI hit 7% yoy (1973), Fed funds were 8% and were over 10% in 2mnths and it still took a while to control inflation.
PPI up 7.2% YOY, with a near monotonic rise since January in YOY prices:
http://www.bls.gov/news.release/ppi.nr0.htm
Even ‘core’ is jumping, up 0.4% in November.
Yeah, Ben, just keep adding liquidity, that’s the answer.
The correct answer is, Ben, shut the spigot and have banks write off the junk. Painful, absolutely. Do it now, voluntarily, or do it later, when it is forced upon you. You choose.
It crosses my mind that the TAF nicely removes junk paper from the balance sheets of major banks just before the auditors look at the end of year balance sheets. Without this, a major bank might show Tier I capital dangerously close to the required capital. It does this in several countries, too. Since it is a term facility, that may be the major effect. Of course, pulling the wool over the eyes of the markets, er, I mean calming the markets might not be the worst of ideas.
ric – not exactly the the outcome that we’re supposed to expect from a Fed that claims to be emphasizing increased “transparency”, is it?
one more big dent in credibility for the Bernanke Fed — they say they believe in increasing transparency, but then produce a truly nutty idea that (a) allows banks to park* securities with the Fed over year-end, and (b) the amounts of the TAF used by participants will NOT be made public.
AAgghh.
* when anyone but the government does it, “parking” securities is ILLEGAL.
I agree with anarchus on the term loan point.
The danger of TAF is it being extended so these loans can be permanently rolled over, changing a term loan to a long term loan. Commercial banks would get cheap loans on bad collateral.
The Fed has changed temporary actions into permanent ones in the past. Remember the severing of the gold window?
The reason the Fed has the power to discount such a wide variety of collateral goes back to 1999, when it extended itself these capabilities in order to deal with the Y2K problem. With Y2K gone (and a dud) that power is now permanent. Who knows, the same sort of thing could happen with the TAF.
ric — that was exactly my thinking. Hide $40 billion of the worst junk just past New Year’s. There’s another possibility, which is that this is just the first TAF. If it goes well (however the Fed intends to measure that), they could decide to repeat it, or even make it a recurring feature. Ugh. I really don’t like the *non-transparency* thing. If a bank is showing good assets, but they have an obligation to return those assets and get their junk back, shouldn’t shareholders and counter-parties have a right to know that?
Hello All,
I occasionally follow across to this blog from Brad Setser, and thought that someone here might know the answer to a question that has arisen there; namely, what difference between Fed funds and LIBOR is making them trade so far apart at the moment?
Thanks for any information on this question.
RebelEconomist, it’s a risk premium, as discussed by Steve Cecchetti. I’ll talk about this also in my post later today.
Thanks……I will look out for your post on the subject.
When a rose is not a rose: TAF is not “just” the discount window
Yves Smith at Naked Capitalism and Accrued Interest have both taken very measured views of the Fed’s new Term Auction Facility, which gets its big start on M…
Don’t Fight the ECB?
Don’t Fight the ECB lacks the alliterative quality of the Marty Zweig formulation, but at this critical market juncture it may be even more important. Background The hot money traders, doing something to score at year’s end, have reacted vociferously
“The claim that this could account for a 2.5% drop in the total value of the U.S. equity markets strikes me as, shall we say, creative.”
James,
What would $500 Billion do to the European Borses?
The “term auction facility” is nothing more than the worlds largest pawn shop.
The banks legally own the Fed, so why shouldn’t the Fed do their masters bidding…
and set up the pawn shop so the banks can pawn their toxic debt for cash at a premium?
Whatever profit the treasury makes will be wiped out by the defaults on the boat loans they are accepting at the window.
Tony Soprano couldn’t have done better.
http://naybob.blogspot.com/2007/12/fed-worlds-largest-pawn-shop.html