Wednesday, December 12, 2007

Leaving Lombard Street 

Today's actions by the Fed and other central banks to create a new "term auction facility" to inject liquidity in the market is very unusual, and the explanations given through Greg Ip's reporting doesn't really explain much. There is a discount facility already in place, not just here but elsewhere. What it does is hold down interest rates during periods when there's some external shock to liquidity. The two graphs to your left show what happens without a discount or Lombard facility and when you do have one. (Click to expand them and read the legends. From the Bank of Japan.) They prevent spikes in interest rates that would cause some loans to reprice and as a result exacerbate the liquidity crunch.

The advice one receives all the way back to Walther Bagehot's Lombard Street in 1873 is that central banks should always lend freely, readily and at a penalty rate. Calculated Risk points out that the Bank of England's leader, Mervyn King, understood Bagehot well last September. If you do not charge a penalty rate, he said, you encourage banks to engage in more risk-taking. This becomes now really a bailout (much more than the cramdown on ARMs in the Paulson-Bush plan working through the Congress now.)

Ip reports the Fed as saying they couldn't get enough lending to banks with the penalty rate -- nobody seems willing to pay it. Reducing the penalty would have also destabilized the Fed funds market. So instead there is an auction -- rates TBD -- based on "a wide range of collateral, the same range as is available at the discount window." We won't know who borrowed, we won't know what the collateral is, and we may not even know the terms. Sounds like very little in the way of transparency, which Mr. Practical picks up:
Essentially, what the Fed is doing is taking the stigma away from the discount window--the Fed will lend directly to banks and the banks don�t have to tell anybody. Theoretically, the Fed could make these quiet loans for indefinite periods, thus giving banks more permanent capital (it�s really credit, but banks call it capital).
Likewise, Floyd Norris:

The Fed will lend money to banks based on almost any asset they own, even ones that are not liquid at all. That will include some of the more exotic loans and securities out there.

Investors, it appears, love it. The stock market opened sharply higher, reducing the losses that came yesterday after the Fed cut interest rates, but not by enough to satisfy Wall Street. This move is taken as evidence that central banks are determined to rescue the system, whatever it takes.

How much will the Fed lend against illiquid assets? It has a public list, already in use in discount window lending. You will note that it allows the lending of up to 85 percent of the face value of AAA-rated collateralized mortgage obligations, if there is no observable market value. There are some C.M.O.�s out there that have not yet been downgraded but that might not bring that much in a sale.

I�d love to see which assets are pledged, and how much the Fed lends against them. But the Fed won�t disclose those facts. Nor will it let us know which banks borrow using the new facility.

Given the lack of transparency, I would consider this little more than a credit rationing device. It does not let the market set the amount of credit absorbed based on a fixed price -- it is inserting a fixed amount of liquidity based on what it is they decide they'll lend against (at whatever rate of discount they choose.) This does not necessarily lend to creation of orderly markets. This does not smooth out interest rate fluctuations from future burps in the credit markets that are bound to happen over the next few months as more and more of these instruments experience stress. I can see what Europe gets from this deal, but why the Fed is doing it is not as clear.

UPDATE: This is excellent:
But this, this is a bailout,. Nearly all government bailouts take the form of subsidized loans, extending credit at low rates to counterparties or against collateral for which the market would have demanded a high premium. That is precisely what the TAF will do. The Fed's press release claims, of course, that loans will only be available to "sound" banks, and that they will be "fully collateralized". But no one who can get the same deal from private markets will use this facility. The need for the program arises because private markets are skeptical about the soundness of counterparties and the quality of the assets they have to offer as collateral. The Fed hints at this when it mentions the "wide variety of collateral" that can be used to secure loans. You can bet that whatever it is private lenders are eschewing will be pledged as collateral to the Fed under TAF. The Fed is going to bear private risk that market refuses to. That is a bailout.
Exactly. So why does Bernanke agree to this? (h/t: Felix Salmon.)

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