Faced With Crisis, The Fed Innovates

Source : The Business Times, March 13, 2008

Latest move different in scale and ambition from what it has attempted so far

THE US Federal Reserve's new Term Securities Lending Facility is arguably the boldest and most innovative step taken so far to clear the logjam in the credit markets since the US sub-prime crisis blew up last August.

Let's look closely at what the Fed has essentially done. It has agreed to lend US$200 billion in the form of Treasury securities to primary dealers (and through them, to other financial institutions) for 28 days against collateral that includes not only US federal government agency debt (including mortgage-backed securities, or MBS), but also private AAA-rated MBS.

There are three key points to note here about how the Fed's actions are different from what it has done before.

First, the amount the Fed is willing to lend has increased significantly. When it first announced its Term Auction Facility in December (aimed at easing liquidity in the credit markets), it capped its lending at only US$20 billion - although this was progressively increased to US$100 billion last week. That has now been doubled, and the Fed has indicated that it could be increased even further.

Second, the loans the Fed makes will now will be for 28 days rather than overnight, as before. This gives banks more time, and flexibility, to act.

Third, and perhaps most significantly, the Fed is now willing to accept as collateral not just US government-backed mortgage securities, but even private sub-prime-mortgage securities (some of which are rated AAA even if they don't deserve that rating). Or as some commentators bluntly put it, the Fed is willing to swap Treasuries for junk.

Whether this proves wise in the long run, we shall see. But in the short run, what the Fed has effectively done is to create a market for a vast pool of illiquid and unwanted securities. The banks which have been stuck with these securities, have been forced to mark them to market - meaning mark them lower and lower as US housing prices have kept falling.

As a result, banks' recapitalisation requirements have kept rising. This, in turn, has not only badly dented confidence in financial markets generally, but has also made banks afraid to lend - which has accelerated the housing downturn (thus jeopardising even non-sub-prime mortgages) and weakened the corporate sector (even healthy companies) and the economy as a whole.

The Fed's latest move will, of course, not solve all these problems at a stroke, and the Fed itself is modest about what it hopes to achieve, saying merely that the new facility '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'.

But with the new facililty, banks will be able to get at least some dubious mortgage assets off their books. In return, they will get high-quality liquid assets in the form of Treasury securities, which can easily be converted into cash. This will help unfreeze credit markets and, to some extent, also insulate banks from falling housing prices.

No surprise, therefore, that at least the initial reaction from Wall Street to the Fed's new facility was positive: the Dow Jones index jumped 3.55 per cent on Tuesday and banking stocks recovered sharply.

However, whether this bounce will turn into a rally remains to be seen. There are reasons to be cautious; a lot of unanswered questions remain. First, just how big can the new facility become? While the Fed has indicated that it will consider increasing it from US$200 billion, mortgage assets on the books of US banks run into the trillions - not to mention other potentially bad loans, notably those provided to leveraged institutions such as hedge funds and private equity funds.

Second, will the Fed roll over the loans after 28 days? How long will it keep doing this? And how, and when, will it dispose of the dubious mortgage assets - the 'junk' - it collects as collateral?

Bargaining chip

Perhaps most importantly, will the Fed (which now has enormous leverage vis-a-vis the banks) require banks using this facility to change their practices? Fed chairman Ben Bernanke has recently been exhorting these institutions to forgive some of the principal (not just interest) on some of their outstanding loans. The harder the bargain the Fed is able to drive on this critical issue - and it would have a lot of popular support - the more likely that it would succeed in staving off the much-dreaded wave of housing foreclosures (which could send the US housing market into free-fall), as with lower principal payments, homeowners would be less 'underwater' on their mortgages.

How this latest Fed move goes down politically in the US in this election year cannot be ignored either. If the move is viewed as a bailout of bankers at taxpayers' expense - and there are already rumblings to that effect - the Fed would be pressured to think again. But for now, Bernanke & Co deserve credit - and the benefit of the doubt - for daring to innovate in the face of a crisis.