naked capitalism

The increase in the size of the Term Auction Facility, from $150 billion a month ($75 billion per two 28 day auction) as of its last auction to $900 billion today (with an interim plan to go to $450 billion that was blown past in this announcement) is an admission that the banking system is not functioning. The size of the TAF, a single facility, now exceeds that of the Fed’s entire recent balance sheet size.

As we noted in previous posts, these liquidity measures have become counterproductive. Citing FT Alphaville:

Liquidity is being thrown at the system, but it’s just making things worse.

By pumping in more money central banks aren’t addressing the fundamental concerns of the banks at all. Going cold turkey is a very unpleasant thing, but the solution isn’t more drugs, even if they alleviate short term pain.

In assuming they can rely on central bank money market operations – which will be expanded (as is the case) when the going gets tough – banks are naturally avoiding lending to each other.:

Persisting in a failed course of action is a sign of desperation.
From Bloomberg:

The Federal Reserve will double its auctions of cash to banks to as much as $900 billion and is considering further steps to unfreeze short-term lending markets as the credit crunch deepens.

“The Federal Reserve stands ready to take additional measures as necessary to foster liquid money-market conditions,” the central bank said in a statement released in Washington today. Fed and Treasury officials are “consulting with market participants on ways to provide additional support for term unsecured funding markets,” the statement said.

Today’s steps follow a hoarding of cash by banks that sent the premium on the three-month London interbank offered rate over the Fed’s benchmark interest rate to a record. Industrial companies are also finding it harder to raise cash after the market for commercial paper shrank to a three-year low as investors flee even borrowers with few links to mortgages.

“It is pretty much all out war,” said Christopher Rupkey, chief financial economist at Bank of Tokyo-Mitsubishi UFJ Ltd., New York. “They are pulling out all the stops to try and get borrowers and lenders to meet and do transactions once again.”

Implementing part of last week’s emergency legislation to shore up the financial industry, the Fed said today it will begin paying interest on the cash reserves banks hold at the central bank. The step should give Fed officials greater power to inject cash into banks without interfering with their benchmark interest rate, which stands at 2 percent.

Fed Chairman Ben S. Bernanke’s speech on the economic outlook tomorrow in Washington should give an indication of whether U.S. central bankers are prepared to cut the main rate before the next meeting Oct. 28-29, Rupkey said.

As part of today’s steps, the Fed will increase its auctions under the 28-day and 84-day Term Auction Facility operations to $150 billion each. The two forward TAF auctions in November will be increased to $150 billion each, the Fed said.

Note that the 84 day auction is a new feature, presumably created when the TAF went to $450 billion as of late September (although no auctions were conducted at that level; the first auction was today). Also, I am surprised at the Fed using 84 day auctions. Its statutory authority limited it to extending 28 day loans. Was a new provision slipped into the 451 page bailout bill?

The article also mentioned the Fed’s new authority, granted with the rescue bill, to pay interest on bank reserves.

John Jansen tells us that, per our comment at the top, that central bank liquidity measures had become counterproductive, the efforts to increase liquidity are not thawing out the money markets:

The money markets have frozen solid again. My favorite correspondent on that market reports that participants are following the advice of Polonius and are refraining from borrowing or lending. The Federal Reserve announcement earlier today of a gigantic increase in the size of the TAF program has not broken the logjam or sweetened the mood.The gentleman with whom I speak on this topic suggests that if we have a few more days of this inactivity and illiquidity, then the direness of the situation will leave the Fed will it will be force to guarantee Libor deposits and commercial paper.

He also remarks that we are at the point of self fulfilling prophecy. On that point he references the S and P downgrade of Royal Bank Scotland this morning.

This makes perfect sense, In the 1930s, it was the withdrawal of deposits by understandably frightened customers, spooked by bank failures, that neutered the Fed’s efforts to increase money supply by expanding the monetary base. Banks in the US (and any country running a significant current account deficit) are dependent on wholesale market funds, and that has frozen with the fear of bank failures. Just as the Fed was unable to reflate until 1934, after the FDIC was created in 1933, so to it make take a guarantee of Libor and commercial paper to get liquidity moving.

But will such a guarantee be credible? Those markets are large relative to GDP, but the answer, at least for commericial paper, is yes due to its historically low default rate. Commercial paper outstandings as of last week were $1.6 trillion, versus a US GDP of $14 trillion. However, pre Lehman, there were remarkably few commercial paper defaults, fewer than 10 in the last decade. Guaranteeing CP on an interim basis (a year?) would have been a far more direct way to go about this than throwing more money at the TAF