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The Fed Giveth, and The Fed Taketh Away
The Fed almost got it right.
I have been whining for some time about the need to use asset market policies, rather than giving people checks so they can buy another iPod, to fix the current blackout in the credit markets. Friday's run on the bank at Bear Stearns has apparently gotten somebody's attention.
The Fed has been nibbling at the problem for some time. On January 22, they lowered their fed funds target by 0.75%, the biggest one-time drop in 2 decades. Then, on March 7, the Fed acknowledged that the Fed funds market was not performing its function by increasing the size of the temporary Term Auction Facility (TAF) they use to mainline reserves directly to banks with liquidity issues to a whopping $100 billion, doubled the length of the loans to 28 days and announced that banks would be able to use mortgage-backed and asset-backed securities as collateral to secure the transactions.
On March 11, the Fed announced a $200 billion Term Securities Lending Facility that would allow financial institutions, including the big investment banks, to borrow cash or Treasury securities using mortgage-backed securities as collateral. But last Friday, things hit the fan at Bear Stearns and the Fed stepped in to provide a non-recourse 4 week loan to Bear Stearns, through JPMorgan Chase (JPM).
Finally, on Sunday, the Fed agreed to fund $30 billion of Bear Stearns' less liquid assets, on a non-recourse basis, to facilitate the JPM purchase of Bear Stearns. At the same time, the Fed announced a 0.25% cut in the discount rate and created yet another alphabet program--this time the Prime Dealer Credit Facility (PDCF) that will provide overnight funding to primary dealers in exchange for a wide range of collateral including "investment-grade corporate, securities, municipal securities, mortgage-backed securities and asset-backed securities for which a price is available." The one day loans can be rolled over each day. The interest rate is the discount rate, currently 0.25% above the Fed funds rate. The Fed has full recourse to the borrowers capital.
Tomorrow, when the Open Market Committee meets, everyone expects them to reduce the Fed funds by another full point, with a corresponding further cut in the discount rate.
So why isn't it working? The answer is in the fine print. When the Fed announced the new PFCF (you have to use acronyms in this business) they also issued a press release, a Terms and Conditions statement and a statement on Frequently Asked Questions (although they had never done this before so I am a little skeptical about how many times it had come up in conversation).
Near the end there are 2 questions we should pay attention to.:
Will the PDCF operations have a reserve impact?
Yes, the credit advanced to the primary dealers under the PDCF will increase the amount of bank reserves.
How will we offset the reserve impact of PDCF loans?
PDCF loans made to primary dealers increase the total supply of reserves in the banking system, in much the same way that Discount Window loans do. To offset this increase, the Federal Reserve Open Market Trading Desk (the “Desk”) will utilize a number of tools, including, but not necessarily limited to, outright sales of Treasury securities, reverse repurchase agreements, redemptions of Treasury securities, and changes in the sizes of conventional RP transactions.
In other words, in conjunction with their Fed funds targeting operation, the Fed will siphon off every dollar of reserves created by the new facility--thereby, negating all of the stimulative impact of the policy! Or, another way of saying the same thing, the Fed will reduce reserves at healthy banks--thereby worsening their liquidity--dollar for dollar with the loans they are making to the investment banks.
As an example, on Monday, March 7, the same day they unveiled the $100 billion facility, the Fed announced they would sell $10 billion of Treasury bills from its portfolio on Monday, March 10 (thereby reducing reserves by the same amount), the first outright sale of securities since 1991.
This is a problem on many levels. Leave aside the obvious moral hazard problem of taking money away from careful people to give it to people who are not so careful. It also reduces the amount of bank reserves in commercial banks--as opposed to investment banks who do not hold deposits. This will further contract lending and worsen the credit crunch.