The Hindu Business Line : Fed’s TAF programme: Just treating the symptoms?

The US Fed, along with four major central banks, has established the Term Auction Facility (TAF) programe to inject more liquidity into the financial system. But this has been met with scepticism by economists and analysts, who feel that pumping in more liquidity will not rectify the lending excesses of the recent past, says K. SUBRAMANIAM

It is rare that central banks act in unison. Even if they do, they don’t go public about it. It was rather unusual for the US Federal Reserve (Fed) to have announced on December 12 the establishment of a Term Auction Facility (TAF) program in concert with four other majors: the Bank of Canada, the Bank of England, the European Central Bank (ECB) and the Swiss National Bank. (The Bank of Japan and Reserve Bank of Australia also voiced their support.)

What surprised the Wall Street was that a day earlier the Fed had cut the fund rates, third time in a row, by another quarter percentage point and met with Wall Street’s mercurial response.

If one word can summarise the Fed’s action, it is “Panic.” Some analysts described it as ‘firebreak’ and others called it ‘bombshell.’ The announcement did raise hopes in the early hours but evaporated before the day was over.

Sub-prime crisis

The sub-prime crisis, which engulfs the financial institutions globally, is different in character from anything encountered earlier. Sadly, Central banks in developed countries were unprepared. When it struck, they would not concede that it was the result of a combination of solvency and liquidity. For weeks they lived in the hope that the market would ‘correct itself.’ That was what their textbooks said.

Soon, the fear of contagion spreading to the real economy gripped and they sprang into action. They behaved like older generals fighting past wars. They were busy cutting rates and pumping in unlimited liquidity. As Financial Times said (The charge of the central banks, December 12, 2007), “Like the commanders of disorderly retreat, central banks have to date staged a piecemeal response to the credit squeeze, to little effect.” It was evident that something more was required in a coordinated way.

Multi-national effort

The attempt through the TAF program is to calm the global credit crisis through a multi-national effort, especially to encourage lending and the flow of liquidity in the financial markets. As Lucas Papademos, Vice-President of ECB, said the actions were “aimed at easing pressures and containing pressures in the term money market.”

Since mid August, confidence had fled the market and liquidity remained frozen. Piecemeal actions were ineffective and as Martin Wolf described, “monetary policy is not being transmitted to the ultimate borrowers.” (Financial Times, December 12, 2007).

What caused anxiety was the widening gap between inter-bank lending rates in the US and the London interbank offered rate (LIBOR). The LIBOR began to command a premium. On December 12, the LIBOR was 5.10 per cent against Feds’ fund rate of 4.75. It was feared it would widen further.

As many analysts explain, the spread between the two rates is a measure of liquidity and how much money is flowing through the system. It would adversely affect the adjustable rate mortgages in the US, which are linked to LIBOR. Further, it would question the efficacy of Fed’s rate as a monetary tool. The surge in money market rates created concerns over the slump in lending exacerbating a slow down in global economic growth.

Reports suggest that the plan was mooted in G-20 and discussed by central bank officials in September and was put off as markets showed signs of stabilisation. It was put through when the markets got worse.

The program widens the participation in short-term financing beyond the big banks and brokers that are primary dealers by allowing US banks to deal directly with the Fed. The lending will be against a variety of collaterals that are used to secure loans at the discount window. All institutions judged to be sound by their central banks are eligible to participate in the auctions and the bids will be sent through their respective central banks. Loans are for a short duration of 28 to 35 days.

New auction facility

The new auction facility will consist of four transactions. The first two auctions of $20 billion each will be on December 17 and 27. The third and final auctions will be in mid-to-late January. The amount and duration will be decided in January. There is a complicated formula to decide the bids and the aim is to bring the Libor and US inter-bank rates closer.

Along side, the ECB and Swiss National Bank have entered into swap arrangements with the Fed to auction $24 billion in dollar funds to banks in Europe. On its part, the Bank of England has also offered to inject a total of £11.35 billion in December and January. The net result would be that banks on both the sides of the Atlantic would have both onshore and offshore dollar funding.

As the Fed sees it, the TAF will be helpful in assessing the usefulness of augmenting the Fed’s current monetary policy tools – open market operations and the primary credit window – with a permanent facility for auctioning term discount window credit

Wrong medicine

Sadly, the whole exercise is mounted on the premise that banks lack liquidity and pouring dollars would save them from the current crisis. Prof Ben Bernanke, long before be became the Fed Chief, was quoted as saying that he would drop dollars from helicopters to save the economy from deflation. He along with his counterparts are pouring dollars from heaven to save the banking system. Sadly, it is a wrong medicine and deals with the symptom and not the disease.

The market has not responded with enthusiasm. On December 14, two days after the announcement of the TAF, LIBOR ruled at 4.97 per cent against the Fed rate of 4.25 per cent fixed on December 11. The first auction results would be available on December 20 and may give a better idea of the market’s response.

By and large, many market analysts take the view, “Although the TAF programme is likely to alleviate some of the credit stringencies in the money markets, it is unlikely to meaningfully correct the lending errors made in this cycle.”

One of the reasons cited for the failures of earlier attempts of ECB, Fed, etc to inject liquidity was the perception that those who seek discount windows are ‘distressed’ and lack credibility. This is a part of the problem.

The idea that anonymous auctions would keep the seekers of funds from public view is pathetic. Firstly, information about the borrowers would become available soon.

Secondly, banks do not seek the loans, as they don’t have creditable collaterals. By now it is common knowledge that the collateral bundles do not have market value and were book keeping arrangements between banks, hedge funds and other non-banking institutions.

The TAF addresses this problem in part. It would accept a wide range of collaterals. It is unclear how the Fed would price them. If the market is not able to price them now, how will the Fed do it? There are also doubts whether it would amount to ‘bailing out’ banks by using public funds. In the press release issued by the Fed there is no clarity on these issues.

It is not surprising that the plan has been criticised uniformly by reputed economists, analysts and by major newspapers. The overall assessment is the liquidity freeze has come about over the years due to banks and their affiliates such as hedge funds accumulating bad debts and hiding them behind fictitious bundles. Banks do not know how much bad debts their counterparts hold and how trustworthy they are for credible dealings.

As Paul Krugman wrote, “Markets won’t start functioning until investors are reasonably sure that they know where the bodies — I mean bad debts — are buried.” In an edit, Financial Times joined in, writing: “The excesses of recent years will have to be worked off, one loan at a time. Fed can ease the pain — but he cannot cure the disease,” (December 15, 2007).

The Fed and other central banks are unwilling to face the core issues afflicting the banks. These were encouraged partly by their attachment to deregulation and to financial innovations. They were unwilling to act in time.

The innovations have come home to roost. Their latest move is an indication of their panic. It will not chase the furies.

(The author, a former Finance Ministry official, has extensive experience in international, financial and trade issues.)

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