As regards the journalist, since the Fed deliberately made the system opaque, we do not know who submitted what collateral. However, it’s a pretty safe bet that the banks are using the worst collateral possible. If they have good collateral, especially Treasuries, they can repo them at much more attractive rates with private banks (although I notice that lately the Fed has been repoing significantly below target Fed funds).

As for defaulting, or more accurately, failure to deliver collateral at term, it happens all the time, even with the Fed. Usually, it’s because the back-office screwed up, wrong CUSIP, i.e. of a technical nature. If they catch it early in the day, no problem, but if it’s late there is a default. The guilty party gets fined, but only at target Fed Funds (if memory serves), so the incentive to fix it depends on the availability of $.

So technical defaults happen all the time. Has anyone heard of a real default on repo with the Fed?

P.S. The FHLB also accepts crappy collateral for repo and has increased loans to its banks. Somehow never see that in the newspapers.

The writeoff estimates widely published refer to “banks” but actually lump in investment banks and in some cases also include foreign institiutions which are not eligible to borrow at the Fed,. The losses have been concentrated in investment banks so far and are likely to continue to be.

John Dizard, in a piece I am in the process of putting up, mentions what a mess the credit markets are in in general. Americans seem to see the eruptions here and there, like the auction rate securities market, or the problems with leveraged loans, yet seem in denial about the danger that this represents.

And TAF volumes remain small relative to the range of estimates for eventual write-offs.

I have not been sufficiently clear here. According to a theory regularly invoked by some serious economists, set forward by Walter Bagehot, in times of stress, central banks should lend against good collateral at penalty rates.

The notion is if you don’t, you create moral hazard. The penalty rate is to punish the banks for having managed its affairs badly; the good collateral requirements is similarly to avoid rewarding them if they make stupid risky bad loans.

So here we have, first, a facility that was supposed to be short-term the Fed now seems to regard as permanent. I’d feel better if they were signaling that they intend to cut it back at some point in the future. Second, it is getting bigger even though conditions could have been expected to improve early in the year, thus lessening the need for it. Third, if what 2:53 says is correct, the TAF is distorting behavior, which is consistent with what Bagehot would expect.

And although I can’t prove it, I do think this is sending distorted signals. If the banking system is under as much strain as the fact that the Fed increased the TAF says, equities shouldn’t be as high as they are.

The FT article and some comments suggest that the Fed (and other CBs) are accepting lower quality collateral. I presume in the event of a borrower defauting then the central bank would take ownership of the collateral. If this happened, what would the effect on the defaulting bank be? Could it survive? And what would the central bank do if the collateral turned out to be worth less than its lendings? Does it just print more money to cover its losses or would it need to sell other securities or assets to cover them. Another point I am unsure about is to what extent can a central bank accept poor quality collateral, would there come a point when the currency markets would lose faith in the currency maintaing its value and thus act to put a limit on the central bank’s ability to accept poor collateral? Do central banks have to report what is on their books like regular banks do, and if not how do the markets form an accurate picture of the health of an economy?

Thanks for any help!

The TAF bidding starts at the relevant OIS swap price, i.e. where the fed effective overnight fixing compounds up to for the duration of the relevant period. The ois (overnight index swap) is basically the markets’ true expectation of Fed rates going forward. Therefore I would argue that getting money from TAF at the lowest possible rate is NOT ‘below market rates’ – but bang on market. The rates that the TAF money comes below (currently, but not not necessarily depending on demand) are the Libor rates…. but the whole point of the TAF (in my view) was to get the Libor rates down and to get the interbank cash market moving again!

All that said, I agree that these TAF auctions or ECB equivalent (3 month LTRO’s) have started to produce the (unwanted/unforseen?) effect of banks creating RMBS and keeping them on the banks books as a quick way, in another liquidity squeeze like August, to access ECB/FED liquidity. Which in itself is simply proper foresight and liquidity management – but at the end of the day it all points to a need for further re-capitalisation of banks or/and decreasing balance sheets.

Newspapers have fact-checkers and standards for reporting. The FT is based in the UK, which has much tougher libel laws than the US, so they probably run a tight ship.

They might have gotten several comments from people who wanted to stay off the record.