Redstate

The Term Securities Lending Facility May Be Working

By blackhedd Posted in Economy | federal reserve | housing | Mortgage Crisis | Subprime | Term Securities Lending Facility — Comments (18) / Email this page » / Leave a comment »

As much as I hate to subject you all to this, here's a piece of seriously complex Federal Reserve news. I'll explain it as best I can, however. The bottom line appears to be: it's good news.

You've certainly heard that the Bernanke Fed have been doing unprecendented, aggressive and creative things in their attempts to stabilize financial markets. (To mitigate the effects of a US recession is an entirely different problem, and not the current priority.)

One of the things the Fed did was to set up a Term-Securities Lending Facility, or TSLF. What the heck is that?

It's a weekly auction, to be held every Thursday for the next six months. The Fed will offer liquid, risk-free Treasury securities from its inventory, in return for specific kinds of risk-bearing securities, notably mortgage-backed securities. They just held the first one on March 27, and although the results are not unambiguous, the auction does seem to have had a material positive impact on the money markets.

Keep reading.

Here's a little more clarity on exactly what the TSLF is auctioning, and to whom:

They're auctioning 28-day loans of specific Treasury securities with a wide range of maturities. Any primary dealer may participate, including certain investment banks and broker-dealers. It's not restricted to commercial banks. Institutions that successfully bid on the Fed's Treasury securities must pay interest on the principal value of the borrowed securities (that rate is what they bid on), and they must supply collateral in the form of other securities deemed acceptable to the Fed.

In effect, the Fed are doing two important things at the same time.

First, they're putting more US Treasury securities out into the market, in a sterilized fashion that does not reduce the overall money supply. This is going to relieve the preternaturally high demand for Treasury debt that has been choking the money markets for weeks now.

How did that work? Pretty darned well. Before the auction, the three-month Treasury bill was trading to yield something like 0.50 percent. That's not a typo. The "handle" literally was zero.

And about two weeks ago, the so-called "specials rate" for overnight repo collateralized by the three-month bill was a negative number. People would literally pay you to borrow their cash, so long as you provided the three-month T-bill as collateral. To my knowledge this has never happened before with the short bill, although it did happen in the late summer of 2003 with the 10-year Treasury note.

After the TSLF auction last Thursday, the overnight repo rate jumped back up to a much healthier-looking number, a little below 2%. (In normal times, it runs just a few basis points below the Fed funds rate, which is 2.51% this morning, far above target.) This suggests that the extraordinary shortage of short-dated Treasury debt has now abated.

The Fed's second key objective, and it's a very interesting one, was to reduce the oversupply in the secondary market for mortgage-backed securities.

This also worked out pretty darned well. The Fed accepted bids for Treasury debt with a par amount of $75 billion. That means they took out of the market mortgage-backed securities amounting to at least that much in face value (probably a lot more, actually).

The sudden decrease in the supply of mortgage-backed securities raised their prices sharply, which reduced their interest yield. You may have noticed that retail mortgage rates suddenly plunged late last week. Now you know why.

Combine this activity by the Fed with the $29 billion they lent to buy up mortgage-backed securities from Bear Stearns, and an exceptionally interesting picture emerges.

The Federal Reserve has embarked on a policy to put a floor under the market for mortgage loans.

Many people have recently expressed fear that the housing market would not be able to clear at current prices, unless it shed a great deal of the leverage being used to fund mortgage lending. Because prices of mortgage-backed securities are falling, holders of these securities have been facing margin calls, which forces them to sell even more. That produces the strange and perverse effect that demand falls as prices fall.

In such an unusual situation, the fear is that there is no equilibrium point between supply and demand, unless you drop the entire housing market to far lower levels, commensurate with the willingness of market participants to hold mortgage debt without leverage. And that would wipe out a good chunk of the economy.

But by removing some of the over-supply in the secondary mortgage market, the Fed appears to have managed to shift the supply curve to the left, where it may again intersect the abnormally leftward-sloping demand curve. This makes it at least theoretically possible for the market to equilibrate at nearly-current levels. That means the Fed may have found a magic bullet to cure the long credit crisis.

It's too early to tell if this will be the result. But the early indications are quite hopeful.

What's the downside of all this?

Simply this: since the Fed is now effectively nationalizing market risk, it potentially exposes itself to monetary losses. This is most certainly uncharted territory for the Fed, which for decades has stuck to the policy of not intervening in markets except as a lender of last resort.

But on balance, I think it's more likely that the Fed will make a profit on these activities. That's because the mortgage-backed securities they're buying have been beaten down far below what is likely their long-term stable value.

You can certainly argue that the Fed are wading hip-deep in a pool they shouldn't have gotten into in the first place. But I think that if they can pull this off and stabilize the financial system (and by extension, the economy), they'll have earned our undying gratitude.

I'd much rather the Fed get into this than Congress, which can't make decisions based on cold-hearted financial calculations. Congress works by making some people happy at the expense of others. When you're spreading pain around, that approach only increases the total amount of pain.

-Francis Cianfrocca ("blackhedd")