Tuesday, March 11, 2008

The F-LEF, or the Federal Reserve Liquidity Enhancing Facility

The Federal Government is in full swing on the current crisis in the financial markets. We have the FHA refinancing subprime loans and financing purchases with no money down (they claim 3% is required but this can be satisfied with a Seller’s Concession for closing costs, and we all know that’s code for raise the price to cover the concession); we have the Federal Home Loan Banks lending hundreds of billions of dollars to the banks on mortgage collateral; we have pressure on the GSEs Freddie and Fannie to step up their participation in the mortgage markets at a time when they are experiencing large losses themselves; we have the fiscal stimulus package (that, in part, increases the amount FHA and the GSEs can lend against homes from the high 300ks/low 400ks to $729k in many markets); and we have the Federal Reserve not only lowering interest rates but also providing $100 billion in liquidity for the banks through the new Term Auction Facility, or TAF. Wow! I have written on all of the foregoing steps taken to blunt the impact of the financial crisis that started with subprime mortgages except the TAF. You can find these articles by clicking on the “bailout” keyword on the list of keywords below. Today I want to look at this TAF.

Several months ago many commentators, including me, where writing about the Treasury plan to create a master liquidity enhancement conduit, or M-LEC. The purpose of this conduit was to be a buyer for assets that struggling SIVs, or structured investment vehicles, needed to liquidate. SIVs, at their core, take advantage of short-term financing at low rates to invest in longer-term assets that pay higher rates making a profit on the spread. When the short term funding dried up because of concern over the value of the assets held by SIVs they were forced to look elsewhere for funding or sell their assets. The problem was that the SIVs could not sell many of their assets into an unfavorable market without suffering losses on those assets. If they were sold at losses investors would suffer and the market could be permanently harmed. Enter the M-LEC that could purchase and hold these assets until the markets returned to “normal” and then sell them or simply hold them until maturity, thereby eliminating the need to sell them at a loss. Of course this raised accounting issues, among others, because if the market value of these assets was below the amount they were sold for the accounting really didn’t work. In the end the M-LEC was never formed. Instead, some banks that sponsored these SIVs ended up taking the SIV assets onto their balance sheets in order to avoid very embarrassing and reputation devastating results of SIV failures. Others were restructured into longer-term debt or liquidated at a hair cut to investors. (There were also liquidity lines from banks to these SIVs at stake, although the reporting on these was and is very confusing.) So in the end, the assets that caused the trouble ended up sold or on the balance sheet of the sponsoring banks.

Now enter TAF, or the Federal Reserve’s Term Auction Facility. This was introduced in December, around the time the M-LEC was originally to be finalized. The TAF is a loan facility from the Federal Reserve to banks. The Federal Reserve has been increasing the amount of the TAF facility in the aggregate from an original $30 billion to $60 billion, and last week to $100 billion. Here is what it does. Bank A needs liquidity to meet deposit withdrawals and/or loan commitments. It can try to get more deposits if it can, but apparently the banks can’t. It can borrow from other banks, but apparently the banks don’t want to lend enough to each other right now either. It can sell an asset on its books to raise liquidity, although this would reduce its profits by shrinking its balance sheet. Or, perhaps it can’t sell an asset on its books to raise the needed liquidity because the market value of the assets is below the carrying value and Bank A would take a loss. Hum, food for thought.

Enter the TAF, where Bank A can pledge assets to the Federal Reserve in exchange for a loan as long as 28 days in duration. Problem solved, Bank A has the liquidity it needs and the markets are not flooded with assets no one wants to purchase. All of this has me wondering – has the Federal Reserve become the Master Liquidity Enhancing Conduit that the banks and Treasury could not work out? The amount, about $100 billion, seems about right. The timing seems about right. It walks and talks like a duck, so maybe it is. I call it the F-LEF, or the Federal Liquidity Enhancing Facility.

The next question that follows is what assets is the Federal Reserve taking against these $100 billion in loans to the banks? Are they those same assets that moved from SIVs and perhaps other asset backed commercial paper conduits sponsored by the banks to the balance sheets of the banks? Seems like a very logical sequence of events viewed this way, so I decided to try to verify whether this was in fact the case. (The banks can pledge collateral that includes mortgage-backed securities, even ones that may contain subprime mortgages). Unfortunately, the Federal Reserve has not, to my knowledge, published a schedule of the collateral it has taken for these loans. So, the usually transparent Federal Reserve has hit a wall of opacity. It is not publicizing which banks are borrowing and it is not disclosing what assets are being pledged against those loans.

I, for one, would like to know what collateral the Federal Reserve is accepting and how it is being valued. Until these facts are made public, I will assume that the Federal Reserve has done what the M-LEC failed to do by creating the F-LEF through which the banks are delaying sales of assets that have been negatively impacted by the changing markets in order to preserve liquidity (or is it the appearance of solvency?). At the same time the banks are being openly encouraged to raise additional capital. So just how solvent are the banks?

Some very interesting questions and issues have been raised by this TAF. On the one hand, some commentators believe it could be the first step to nationalizing the banks (see this article by Steve Randy Waldman). If there are margin calls on the collateral that the banks cannot meet, what is the Federal Reserve to do? Convert the loan to equity? Interesting point. One colleague of mine suggested the Federal Reserve could simply forgive a portion of the debt, or “write it down”, just like the Federal Reserve Chairman Ben Bernanke is suggesting lenders should do with mortgage loans that are more than the property values securing them. That would raise a lot of very interesting issues. Others have said this is just a more effective way to provide needed liquidity to the banking system and should be well down the list of current concerns (see this article by Caroline Baum in Bloomberg).

Stay tuned – I have a feeling this isn’t over yet.

(Ordinarily banks that are solvent can borrow from the Federal Reserve using the Discount Window. The TAF is different in several ways. First, the Federal Reserve will not publish the names of the banks that win the auctions so we just don’t know which ones they are. These loans are also much longer in duration at 28 days and the Federal Reserve has assured the markets that it will provide these lines of credit for at least six months unless market conditions clearly show they are no longer needed and will increase the size if necessary. In the Federal Reserve’s words:

First, the amounts outstanding in the Term Auction Facility (TAF) will be increased to $100 billion. The auctions on March 10 and March 24 each will be increased to $50 billion--an increase of $20 billion from the amounts that were announced for these auctions on February 29. The Federal Reserve will increase these auction sizes further if conditions warrant. To provide increased certainty to market participants, the Federal Reserve will continue to conduct TAF auctions for at least the next six months unless evolving market conditions clearly indicate that such auctions are no longer necessary.)
For more details about the TAF visit the Federal Reserve's website.

Sphere: Related Content

1 comment:

DAL said...

cool blog and great commentary. as a current jd-mba student, I am glad to see other likeminded people further along in their career.

I have been blogging on similar topics myself since june

check it out if you have a second: