Bernanke’s “Rabbit Out Of The Hat” Trick; the TAF (Term Auction Facility)

``The boom can last only as long as the credit expansion progresses at an ever-accelerated pace. The boom comes to an end as soon as additional quantities of fiduciary media are no longer thrown upon the loan market. But it could not last forever even if inflation and credit expansion were to go on endlessly. It would then encounter the barriers which prevent the boundless expansion of circulation credit. It would lead to the crack-up boom and the breakdown of the whole monetary system”- Ludwig von Mises Human Action p.555

Our notion of the US Federal Reserve’s seeming insouciance was nevertheless reversed…a day after it tepidly raised its interest rates. In an apparent orchestrated effort led by the US Federal Reserve to combat the global credit gridlock, major central banks which included the European Central Bank, Swiss National Bank and Bank of Canada agreed to auction credit at favorable rates and to implement swap arrangements. In short, the Fed pulled proverbial “rabbit out of the hat”.

From the Australianews, ``It is understood the joint effort will make available more than $US100 billion ($A114 billion) this month. The US Federal Reserve is injecting $US40 billion; the Bank of England $US46.4 billion, the European Central Bank (ECB) $US20 billion, the Swiss National Bank $US4 billion and the Bank of Canada is providing $US3 billion.”

The joint effort is called as the temporary Term Auction Facility (TAF). According to the Federal Reserve (underscore ours),

``Under the Term Auction Facility (TAF) program, the Federal Reserve will auction term funds to depository institutions against the wide variety of collateral that can be used to secure loans at the discount window. All depository institutions that are judged to be in generally sound financial condition by their local Reserve Bank and that are eligible to borrow under the primary credit discount window program will be eligible to participate in TAF auctions. All advances must be fully collateralized. By allowing the Federal Reserve to inject term funds through a broader range of counterparties and against a broader range of collateral than open market operations, this facility could help promote the efficient dissemination of liquidity when the unsecured interbank markets are under stress…

``The minimum bid rate for the auctions will be established at the overnight indexed swap (OIS) rate corresponding to the maturity of the credit being auctioned. The OIS rate is a measure of market participants’ expected average federal funds rate over the relevant term…

``The Federal Open Market Committee has authorized temporary reciprocal currency arrangements (swap lines) with the European Central Bank (ECB) and the Swiss National Bank (SNB). These arrangements will provide dollars in amounts of up to $20 billion and $4 billion to the ECB and the SNB, respectively, for use in their jurisdictions. The FOMC approved these swap lines for a period of up to six months.”

These measures starkly reveals of the priorities of the US FEDERAL Reserve. It purportedly addresses the unraveling credit crunch or of the burgeoning illiquidity in the marketplace, whose aggravation could lead to a meaningful curtailment of the economic activities. So despite the meager amounts of the contingent liquidity provided for, relative to the total financial markets, such telegraphed actions have succeeded to temporarily narrow the spreads of the LIBOR rate from that of the target FED RATE as shown in Figure 1, courtesy of Northern Trust.

Second, the program deals with the stigma of banks borrowing from the discount window. Banks have been reluctant to borrow from the discount window because of the association of being “troubled” or “distressed”. So, under the new auction system, banks will be lent directly and quietly away from the prying eyes of the public.

Third, the measure aims to accept a much larger scope of collateral, which brings the question of the moral hazard of bailouts.

John Carney of dealbreaker.com says that the FED has announced that it will pay 85 cents on the dollar for CDO’s with no market price available. So effectively, the Fed under such circumstances will be providing cover or subsidies to distressed institutions holding “toxic wastes”.

Thus, Paul Kasriel of Northern Trust (emphasis ours), brings to light the ramifications of TAF, ``A question arises as to whether the Fed will be taking a large enough “haircut” on some of the collateral being presented to it by successful TAF bidders. If the markets cannot price some of these securities, how does the Fed know what they are worth? If a TAF borrower were to become insolvent, the Fed might not be able to recover the full amount it had loaned the bank. In effect, the TAF program, as well as the regular discount window facility, transfers credit risk to the Fed, which means ultimately, to the taxpayer. Depending on how the Fed prices the collateral presented to it, the TAF program could be construed as a taxpayer subsidy to banks presenting “questionable” collateral. Remember, there is no such thing as a free bailout.”

Here, central banks are seen clearly fighting the onset of deflation with inflation and the consequent socialization of financial markets. The odd part is that markets always get the blame for a bust which has been created and fostered by preceding inflationary policies.

Lastly the swap arrangement deals with the proviso of extending standby US dollar supplies to the ex-US financial marketplace in the face of a liquidity crunch.

Prof. Willem Buiter calls such policies as meaningless or “a substitution of motion for action” since it does not deal with the underlying problem of general liquidity, from Financial Times (highlight ours),

``So talk of a US dollar scarcity in the euro area is hilariously silly. In 1947 there was a US dollar shortage in Europe. There was limited current account convertibility of the European currencies and effectively no capital account convertibility. This, however, is 2007. If commercial banks or other market participants want more US dollars, they can buy them in the foreign exchange market or borrow them. In the Eurozone, they would need liquid euro assets to buy US dollars, or they would have to borrow US dollars, secured or unsecured. Indeed they could borrow euros (secured or unsecured) and use these to buy US dollars. All these courses of action are problematic today because there is a shortage of liquidity in the Euro area, that is, a shortage of euro liquidity, US dollar liquidity, Swiss franc liquidity or indeed any kind of liquidity. If there were adequate euro liquidity, commercial banks or anyone else could use that euro liquidity to buy eminently convertible US dollars in the extremely liquid foreign exchange market. The ECB could choose to sterilise its loss of US dollar reserves or not; it could chose to restore its US dollar reserves, or not. End of story. Dollar shortage - my foot.”

Nonetheless, such concerted actions by the key central banks highlight on the severity of the stress envisaged by the global financial markets. In fact, the overcast of gloom and doom scenarios appear to be today’s du jour outlook.