Friday, June 26, 2009

TAF - the Fed program that worked

The Term Auction Facility (TAF) got little attention in the media but was actually one of the key ingredients in stabilizing the financial system. It provided the lubricant when other sources of funds became scarce.

Money markets actually went into a disarray late in the summer of 07, long before the media started calling it the financial crisis. At the time people were only referring to this as the sub-prime problem, but in fact it was an utter destruction of the asset-backed commercial paper market. Money market investors concerned with rising sub-prime default rates refused to roll some half a trillion of commercial paper. Remaining asset backed commercial paper mostly shifted to overnight maturities (with participants rolling daily). The interbank market became jittery as well, with limited term funding. Related to this there was worry about Bear Stearns who's major hedge funds got hammered directly by the sub-prime losses.

The video below is the famous Cramer freak-out. Remember this is August, 2007. Cramer is trying to say that Bernanke is not picking up the fact that money markets have become dysfunctional. He's pushing to have the Fed open the discount window to investment banks.

The Fed listened, but was just slow to respond. They also had a legal problem lending to broker dealers directly, as only commercial banks could legally use the discount window. The Fed decided to deal with the problem by providing term liquidity to all commercial banks across the country and hope that liquidity will find it's way across the financial system.

Banks needed term funds - funds much longer than overnight. No bank treasurer wanted to wake up one morning to find her bank can't roll short term debt. It's lights out. So the Fed came up with the Term Auction Facility (TAF) that helped replace some of the lost term commercial paper and term interbank lending (which is what sets LIBOR). TAF loans had to be securitized with the same types of securities and haircuts as the Fed's discount window. The Fed later massively broadened the types of collateral it takes. The maturities were 1 month and 3 months. The funds were auctioned at preset amounts. The chart below shows the history of TAF auctioned: supply provided by the Fed (green), demand that participants indicated (blue), and the actual funds placed with the banks (purple).

Now roll forward a year to November-08. Not only was the asset backed commercial paper market nearly gone (banks effectively bought their own commercial paper just to keep the programs going), but now the interbank marked has collapsed (even the overnight market was in trouble.) LIBOR settings were all fake - there were basically no term loans among different banks. The repo (overnight securitized lending) markets became shaky as well. After Lehman anybody could be next: Citi, RBS, UBS, BofA? Name it.

TAF went into overdrive. The Fed was taking all sorts of securites as collateral now and pushed the auction far above the perceived demand. It was no longer a limited supply that banks had to bid for (the green line went above the blue). $300 billion of funds was offered in October and $600 billion in November. TAF effectively became the term interbank market. In 09 as things started to calm down, the Fed brought the auction levels back to $300 billion a month and kept it there. The message was simple: you need to borrow funds and you are a bank, here it is, as much as you need. It was the only way to put some confidence back into the system.

Just in the last 3 months or so the interbank market started to stabilize as banks realized that all governments will go to extremes to keep the banking system alive. Given the slope of the LIBOR curve,

banks can borrow overnight and lend term, making a good spread. Corporate and retail deposits are up significantly and banks now feel comfortable placing the money term with other banks (vs. buying treasury bills as they have been doing earlier.) That got the interbank market moving. The Fed now wants to reduce dependency on TAF as the gap between the green and the blue line widens. From the Fed:

In recent months, conditions in wholesale funding markets have improved, and partly as a result, usage of the TAF and the dollar facilities provided by foreign central banks has declined notably. For some time, amounts bid at TAF auctions have fallen short of the amounts auctioned. In view of the decreasing need for TAF funding, the Board has reduced the amounts auctioned at the biweekly auctions of TAF funds from $150 billion to $125 billion, effective with the auction to be held on July 13. The Federal Reserve anticipates that, if market conditions continue to improve in coming months, TAF funding will be reduced gradually further.
"from $150 billion to $125 billion" is twice a month, so we are looking at going from $300 a month to $250 and lower. Because of all the hype around TARP, people paid little attention to this program, but it turned out to be quite effective. Going forward, tracking the "blue line" on the graph is going to give us an idea of the demand for funds outside of the wholesale funding markets, which is an indicator of the health of the financial system.
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