The Fed Says Its Collateral is Fine, Thank You Very Much

There has been a fair bit of discussion on the Web about the Fed’s Term Auction Facility, including some concern that the TAF was enabling banks to post lower-quality collateral than they might otherwise (we had observed previously that the collateral permitted and the haircuts applied are the same as for the discount window).

Surprisingly, no doubt reflecting the level of concern, the New York Fed had a chat with the Financial Times about this topic, making predictable reassuring noises. I found this discussion persuasive until I came to, “the Fed also says it lends only to sound banks.” Yes, and all the children in Lake Woebegone are above average.

From the Financial Times:

More than half the collateral backing cash advances made by the Federal Reserve to banks operating in the US is in the form of loans rather than securities, the New York Fed has told the Financial Times.

This is the first time the Fed has offered any insight into its collateral portfolio, and the news is likely to diminish market concerns about the nature of the assets backing the Fed loans.

Many analysts speculated that banks could be parking with the Fed only complex housing-related securities that cannot be refinanced elsewhere.

However, the Federal Reserve Bank of New York told the FT that since the credit crisis began, banks had continued to provide a wide variety of assets as collateral – including Treasuries, other government and agency-backed securities, as well as private-label mortgage-backed securities.

This may be because borrowers are placing collateral with the Fed not simply for refinancing purposes, but as part of contingency plans to ensure access to emergency liquidity should they ever require it.

The high share of loan collateral suggests that smaller banks, which do not have large portfolios of securities, are active users of the Fed’s liquidity support facilities.

Since the credit crisis erupted in August, the Fed has tried to accommodate the private sector’s desire to hold more liquid assets by taking on more illiquid assets itself as collateral.

In December the US central bank unveiled a new credit auction facility as part of a co-ordinated global assault by central banks on strains in the money market.

The Fed currently has $60bn (€40bn, £30bn) four-week loans outstanding through this programme.

The enhanced liquidity support operation has led some analysts to raise concerns about the risks the central bank is taking on. However, officials believe these are minimal.

As a central bank, the Fed is not exposed to liquidity risk. It is exposed to credit risk, and that exposure has necessarily increased as it has extended larger-scale loans for a four-week period using pre-crisis collateral and margin guidelines.

However, officials believe they have tough safeguards in place.

Unlike many other central banks, the Fed pools all the collateral provided by a given institution. This means all the collateral is available to back up any of the loans made to it.

Because much of the collateral is posted on a precautionary basis – to ensure access to liquidity in an emergency – the Fed’s outstanding loans are heavily overcollateralised.

In addition, the US central bank accepts only a designated list of investment-grade securities and applies what it believes to be a conservative “haircut”.

While it does accept some thinly traded securities, the regional Fed banks have discretion to refuse them, apply increased haircuts or require that they form only a small proportion of the collateral pledged by any institution.

The Fed also says it lends only to sound banks, irrespective of collateral. Officials believe that as banking supervisors they have better insight into the soundness of the institutions using their facilities than European central banks that do not have supervisory responsibilities.

Debate continues to rage in the UK and eurozone over the extent to which central banks should accept housing-related securities as collateral for loans.

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  1. Independent Accountant

    In 1979 Barron’s printed this joke: How do you know when the chairman of the Fed is lying? Answer: Every time he moves his lips.

  2. Anonymous

    Implicit in the question of the quality of the collateral the FED accepts for its loans, is the question of the solvency of the FED itself. Granted that there is no prospect for the financial failure of the FED, the question remains what would the economic failure of the FED look like. Would there come a point when no private sector bank would be interested in accepting FRNs? And what would the financial and economic world look like if that were the case?

  3. Anonymous

    I thought all the kids in lake Woebegone had IQs of zero, to allow every other town to be above average.

  4. S

    is it me or is the annoucnement that the treasury reversed course and is now prodding the IMF to sell gold a bit suspicious. This is as clear and transparent an example of the Gov’t trying to manipulate the market as I have ever seen. Think they are afraid of the technicals and the inflation concerns. Look for a scary PPI number tomorrow.

    The TAFY auction opaqueness is against every free market convention the US espouses. Collateral requirments nothwithstanding, the fact remains that this information is critical to the efficient functioning of the capital markets, far greater in magnitude than the lame prosecutions for FD breachs.

    The news about S&P eliminating watch on the monolines is yet another example of the now visible hand. Why would you play a game that is so overtly manipulated – another question the Fed/Tres hopes slips by the wayside. Is it any wonder the bulk commodity markets are seeing such massive flows, it apears to be beyond the reach of the visible hand.

  5. max

    However, officials believe they have tough safeguards in place.

    For some reason this sentence does not inspire confidence. Anyone have any ideas why?

    In addition, the US central bank accepts only a designated list of investment-grade securities and applies what it believes to be a conservative “haircut”.

    Maybe this why it is crucial for them to shuffle the Ambac/MBIA situation for as long as possible, to maintain the appearance of the “investment grade securities”.

  6. eTrader

    I’m just wondering how those banks describe the TAF money on their balance sheet. It should be categorized as “short term debt”. If the banks roll over TAF this month, the amount will be shown up their balance sheet.

    This is not desirable situation for the banks. They wanted to borrow from Fed anonymously.

    And it brings one question: Do banks roll over TAF this time?

    If they do, investors would realize which banks are insolvent without TAF.

    If they don’t, they have to go back to pre-TAF situation. Hello, LIBOR spread.

    If none of banks shows spike of short debt, and if Fed’s borrowed reserve keeps negative, the game would be over.

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