Wednesday, 12 December 2007

The FED and liquidity

It has become too much of a cliche to post a picture of the deep blue sea before talking about liquidity risk, so here's a muddy river instead...

With that out of the way, the news is that the FED is modifying its liquidity arrangements, allowing it to provide repo facilities to banks without using the window. Details are scant so far, but clearly the FED is worried about the size of the three month swap spread, and it is using both of the tools available to it -- rates and the management of liquidity premiums -- to calm the markets.

Update. Ah. This is all part of coordinated central bank action. Interestingly:

The Bank of England will increase the amount offered in its next auction on 18 December from £2.85bn to £11.35bn, of which £10bn will be offered for three months.

Crucially, it will accept a slightly wider range of assets as collateral for the loans.

The FED press release describing its new term auction facility is here and the WSJ comment is here. From the latter:

At the discount window, the Fed can accept numerous types of collateral, including riskier subprime mortgage-backed securities, as long as the value of the collateral exceeds the loan by enough to protect the Fed from loss. But though the Fed eased the terms and cost of such loans in August, banks continue to shun them for fear of appearing desperate.

Under the new method, the Fed will hold four auctions of discount-window credit. The first two, for $20 billion each, will be held next Monday and Thursday for four- and five-week terms, respectively; two more, for undetermined amounts, will be on Jan. 14 and 28. The auctions are structured so that the rate on the loans will be no lower than the market's expectations for the fed-funds rate, and probably no higher than the discount rate.


Clearly this is a helpful step from the FED and the comment has mostly been positive. Ken Thompson, chief executive of Wachovia said:

More than lowering rates in the economy, just having this banking system liquefied will make a huge difference...

[The reason rates for loans among banks are so high, he said, is that banks and investors] are still fearful of each other and everybody is worried about counterparty risk and so people are hoarding their balance sheets, and this will help that.

Watch the 3m swap spread and see what happens. Ooops.

One final update. Dealbreaker.com points out that the FED is using very old repo haircuts. 85% for a AAA CDO with no mark is indeed generous. Surely they will notice this and fix it. Unless they intended to blow the current liquidity premiums out of the water.

Meanwhile interfluidity takes a dim view of the TAF. One of the points they make is that the TAF is large compared with FED borrowing for much of the year. That's true, but it is still small compared with the problem: a single big conduit is tens of billions of dollars, roughly the size of the entire TAF. To make a real difference, the central banks need to parachute in hundreds, not tens of billions.

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