Introducing your new bad boy, the $200B TSLF

The wave of cash keeps on coming. This is a new level of seriousness about liquidity risk management in the latest annoucement from the FED. From Bloomberg:

The Federal Reserve, struggling to contain a crisis of confidence in credit markets, plans to lend up to $200 billion in exchange for mortgage-backed securities.

The FED statement itself makes the mechanism clear:

The Federal Reserve announced today an expansion of its securities lending program. 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.

This action is also coordinated with other central banks, and simultaneously the FED is increasing the size of its swap lines with, amongst others, the ECB. See FT alphaville for more comment and links to the other central bank announcements.

If this does not bring Agency spreads in under 200bps, we are in such trouble... As Krugman puts it, this is a big slap in the face for the market. Or if you insist on doing without hyperbole, an extensive exercise in sterlised monetary intervention on the asset side of the balance sheet. I prefer 'slap in the face' myself.

Update. The FT in an editorial is not sanguine that the TSLF will have much effect:

Whether it has any effect depends, as it has with every central bank intervention since last July, on whether this is a crisis of liquidity or solvency. If it is simply the case that banks do not have the cash to lend against mortgage bonds then this will have an effect. If, on the other hand, banks are worried that the mortgage bonds or their owners will default, then they will be unlikely to lend even if they can refinance at the Fed.

Banks’ need for liquidity is hard to observe directly, but the evidence implies that the greater problem is solvency, and that the latest intervention will therefore have little effect. First, the price of insuring the credit risk of banks’ own debt has soared, suggesting worries about their solvency. Second, even triple-A mortgage bonds have fallen in price, and a number of leveraged investors, such as Peloton Capital, have failed. That suggests ample reason to worry about repayment. Third, Wall Street banks insist that they have plenty of cash.

I don't entirely buy this line of argument: you cannot split liquidity completely from solvency, in that if an asset turns illiquid, its price falls reflecting that extra risk. Yes, banks might have enough cash short term to meet their obligations. But if the FED can liquify these newly illiquid assets - MBS - then it can address one of the major causes of solvency concerns. Liquidity support is price support in this sense.

Note also that the FT is buying the conventional line that the cost of insuring a bond reflects the market's perception of default risk. That just isn't so at the moment in the main. It reflects the fact that there are more buyers of protection than sellers, mostly due to deleverage. The 'arbitrage' relationship between probability of default and CDS spread only holds if there is enough risk capital around to pull the spread in if it goes wide by selling protection. That is not the case today.