Term Securities Lending Facility

The big news today that spurred the markets into action was that the Federal Reserve will be introducing a new Term Securities Lending Facility (TSLF) similar to the Term Auction Facility (TAF):

Under this new Term Securities Lending Facility (TSLF), the Federal Reserve will lend up to $200 billion of Treasury securities to primary dealers secured for a term of 28 days (rather than overnight, as in the existing program) by a pledge of other securities, including federal agency debt, federal agency residential-mortgage-backed securities (MBS), and non-agency AAA/Aaa-rated private-label residential MBS. The TSLF 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. As is the case with the current securities lending program, securities will be made available through an auction process. Auctions will be held on a weekly basis, beginning on March 27, 2008. The Federal Reserve will consult with primary dealers on technical design features of the TSLF.

What Are The Incentives?

Mish had a couple of great posts about this today: 1 2. He says:

The TAF, the PAF, lowering interest rates etc. are measures that can only work if the problem is lack of liquidity. The problem is not one of liquidity. The problem is solvency. Massive amounts of credit was created out of thin air because fractional reserve lending allows it. Speculation in assets went through the roof when the Fed held interest rates too low too long.

I would only add that the securitization of risk and its offloading from bank balance sheets to various buy side yield chasers that freed up capital for more loans created highly misaligned incentives. Understanding the incentives is key to understanding the situation we are in currently. Knowing that they could unload all the "toxic waste" onto naive yield chasers ("no warning can save a people determined to grow suddenly rich" -- Lord Overstone), banks and other lending institutions had the incentive to underwrite marginal loans, securitize, and sell them. Add the ratings agencies into the mix with their pay-to-rate model and you have some highly highly skewed incentives driving large amounts of capital and credit. The final piece of the jigsaw is the duration mismatched assumption that short term instruments (eg, ABCP) could be used to permanently fund the purchase of long term assets relying on perfect liquidity in credit markets. Playing with someone else's money creates the incentive for high variance bets, and the stage is set.

Mish continues:

Now with falling asset prices, margin calls are running rampant. Margin calls beget margin calls in an ever escalating chain reaction. Carlyle Capital, a once $32 billion fund, was Hit With Margin Calls And Default Notices. It may have to liquidate. If it does, most of that $32 billion will be wiped out because of the 32:1 leverage it was using.

With the TAF and now the TSLF, the Fed has been taking a very unorthodox approach to monetary policy. They appear to be both inflating and deflating at the same time! Please see the following articles.

Bernanke's Surprise.
Repurchase agreements and covert nationalization.
Monetary policy using the asset side of the Fed's balance sheet.
Bennie and the Monetary Jets.
Paul Krugman.

Solvency, Not Liquidity

The net effect they are trying to achieve, from my understanding, is that they are providing liquidity without increasing the money supply. I have argued elsewhere that money supply growth is inflation, not rising prices. The Fed knows this. However, it appears that many banks (especially Lehman and Bear) are holding large numbers of "level 3" assets -- those that cannot be reasonably priced. Today "level 3 asset" is a euphemism for "coming write down." The Fed knows this too. Their solution, eventually, is to provide liquidity via the level 3 assets. Let me say that again: the source of the illiquidity is that many of these assets cannot be reasonably priced, and hence traded. (Nor does anyone want that because it would result in further write downs.) However, if one could use them for repo's, they are no longer sitting idle on the balance sheets but working as capital to enable further credit creation. An essential for an economy experiencing withdrawal symptoms. The auction facilities currently do not accept level 3 assets, but that may well change.

However, this is just a band-aid. The problem is solvency, not liquidity. Well, that's not entirely true. Liquidity is the immediate problem that could precipitate a meltdown, but solvency is the fundamental problem that the Fed is hoping to hide. Unfortunately, I am at a loss to see how it could possibly be solved. The Fed appears powerless unless Congress jumps in and vastly expands the its bag of tricks allowing it to outright purchase these securities instead of merely monetize treasury debt or engage in repo's and reverse repo's. Congress has already somewhat credibly signaled its intent to do exactly that with the recent economic stimulus bill which conveniently had clauses related to Fannie Mae and Freddie Mac's caps. I'm not sure exactly what happened with that, but just the fact that they would try to sneak it in suggests they recognize the severity of the crisis and are willing to nationalize if need be to avert a disaster.

So perhaps this really is covert nationalization...