The Fed Gets Creative

The Federal Reserve announced yesterday the creation of the new Term Auction Facility – or TAF – designed specifically to inject funds into the struggling U.S. commercial banking system still suffering subprime mortgage-related credit problems. While some have dismissed the new initiative as just another form of the Fed’s discount window lending facility, others see it as a way for cash-starved banks to build up much-needed reserves without taking on the stigma associated with the discount window program.

Justifiably or not, borrowing from the discount window is still seen as an act of desperation for an institution that has no other means of obtaining funds and fails to meet the stricter borrowing conditions associated with the federal funds transfer system. In the past, the Fed has done little to change this perception as it typically maintains the discount window interest rate at one percent above the federal funds rate. This is seen in the industry as a punitive rate reserved for those borrowers deemed to be a greater risk.

To answer concerns expressed by some borrowers, the Fed did lower the discount window rate to within a half point of the federal funds rate this past August. This resulted in only a slight increase in usage however, no doubt partly due to the half-point premium still required to access the discount window. Despite the rate change, an aversion to the discount window still exists as evidenced by William Dudley, Executive Vice President of the Markets Group of the Federal Reserve Bank of New York. In a recent speech he noted, “The so-called ‘stigma’ from borrowing from the window exists, in part, because the borrowing occurs at a penalty rate.” ^[1]

Each Term Auction Facility offering will be for a fixed amount with interest charges – referred to as the stop-out rate – determined by the bidding process. Each auction will have a minimum opening interest rate set by the Fed using the overnight indexed swap (OIS) rate ^[2] as a guide – this rate will be posted to the federal reserve website prior to the auction.

Depository institutions planning to bid, must submit offers though their local Reserve bank and all loans must be fully collateralized. The Fed has announced that depository institutions can offer any form of collateral already acceptable for other Federal Reserve lending programs, including the less stringent discount window.

Presumably, some of this collateral will include securities with possible subprime exposures so there is some question as to the level of risk the Fed is undertaking in order to provide these funds. The banks themselves have little faith in much of the collateral presently being offered and those with reserves are loathe to risk their capital in the inter-bank lending system.

In reality, the Federal Reserve had little choice but to ensure sufficient liquidity in order to maintain the integrity of the overall banking system. Creating a temporary monetary tool like the Term Auction Facility should send a strong message to the industry that the Fed is willing to look at new options to combat the global credit crisis.

There are four TAF auction dates currently scheduled:

Reciprocal Currency Arrangements

In addition to the TAF announcement, the Federal Open Market Committee (FOMC) also entered into a temporary currency swap line agreement with several other central banks. The FOMC approved immediate currency swap lines with the European Central bank (ECB) and Swiss National Bank (SNB) to provide both central banks with $20 billion and $4 billion respectively for a six-month period. The Bank of Canada has also been active with a recent quarter point reduction to 4 ¼ for its overnight target rate.

No further currency swap announcements have been made at this time, but there could be additional details early in the new year.

Update – December 21, 2007

Results of the first two auctions are available on the federal reserve website and are summarized in the following table:

• Stop-Out rate is the highest rate submitted by any of the bidders

The Federal Reserve Board of Governors also announced today that TAF auctions will be offered for “as long as necessary”. The full text of the announcement is reproduced below:

The Federal Reserve Board of Governors intends to conduct bi-weekly TAF auctions for as long as necessary to address elevated pressures in short-term funding markets. The Board of Governors will announce the sizes of the January 14 and January 28 TAF auctions at noon on January 4, 2008.^[3]

References

1. ↑ William C. Dudley, Executive Vice President, Federal Reserve Bank of New York – Speech to the Federal Reserve Bank of Philadelphia, October 17, 2007
2. ↑ The overnight indexed swap rate (OIS rate) is based on the expected average federal funds rate for the term of the funds.
3. ↑ Federal Reserve Press Release – December 21, 2007