Fed isn't getting snookered by collateral risk

ANALYST'S VIEW

Ever since the Federal Reserve created a Term Auction Facility in December to ease the strains in the interbank-lending market, the TAF has been a source of agitation in certain conspiracy-prone circles.

The thrust of that argument goes something like this: The Fed, which is first and foremost a counterfeiter, printing money at will, is now accepting low-quality collateral as security for 28-day loans to banks whose anonymity is protected. In the process, the central bank assumes credit risk and lays it at the feet of the US taxpayer. Maybe it's time to take a look at some of the facts.

The Fed had already taken steps in August to encourage banks to borrow directly from its discount window, compressing the spread of the discount rate over the federal funds rate to 50 basis points from 100 and expanding both the type of collateral it would accept and the terms of the loans to 30 days.

No matter how nicely the Fed asked, banks were unwilling to incur the stigma associated with discount window borrowing, especially at a time when financial institutions were reporting large losses and any intimation of trouble could cause depositors to take flight.

Fed Chairman Ben Bernanke decided to respond to the liquidity crisis with, appropriately, added liquidity. That didn't stop the yammering about the assumption of credit risk by the central bank.

The misinformation surrounding the TAF has reached such epic proportions, at least in my small world, that I decided to compile my own version of frequently asked questions and answers. Most of this information is publicly available on the Fed's website - in excruciating detail. But hey, never let the facts get in the way of a good conspiracy theory.

What is the difference between the discount window and the TAF?

About 50 basis points, at least at the February 25 TAF auction. The minimum bid at the auction is determined by the expected fed funds rate over the term of the loan, which is 28 days. The Fed awarded $30 billion at 3.08 per cent last week. The discount rate is 3.5 per cent. (That rate doesn't include the implied cost of any stigma that accrues to the borrower for going to the window.)

What does a bank have to do to qualify for a loan from the Fed?

Banks must be in sound financial condition to be eligible for so-called primary credit. They must file the necessary documentation, as set out in Operating Circular No. 10. And they have to pledge collateral in advance of a request for a discount-window or TAF loan. Many depository institutions regularly post collateral with the Fed in case they need backup funding when money markets are tight, loan demand spikes or depositors withdraw money unexpectedly. Since August, when the interbank market froze up, banks have increased the amount of collateral posted with the Fed.

What sort of securities and loans will be accepted as collateral outside of the traditional US Treasury and agency securities?

Corporate and municipal bonds, money-market instruments, asset-backed securities, collateralized-mortgage obligations and various consumer, commercial and industrial, agricultural, residential and commercial real-estate loans.

How does the Fed determine how much to lend against the securities and loans it accepts as collateral?

A table of recommended margins for various types of collateral is posted on the Fed's website. The Fed lends only a percentage of the market value of the collateral, with the "haircut" ranging from 2 per cent on short-term, top-quality Treasuries (in other words, the lendable value of a two-year Treasury note is 98 per cent) to 40 per cent for certain types of consumer loans.

Some of the collateral the Fed is accepting is exactly what got the banks into trouble. Why will the Fed do a better job of managing risk when it missed the bad-loan problems at banks it regulates?

The discount-window officers at the 12 Federal Reserve District Banks have discretion in determining both the fair value of the collateral and the required margin. If there is no market price for a given security and the discount-window officers and/or bank-supervisory officials at the Fed aren't confident about the value, they can impose a bigger haircut. Alternatively, they can just say no. In the current environment, it's safe to say the Fed has been erring on the side of too much rather than too little collateral.

What happens if the value of the underlying collateral takes a dive during the 28-day term of the loan?

The same thing that happens in the private sector: the borrower gets a margin call. If the value of the collateral deteriorates, the Fed can consider other collateral in the borrower's pool as a backstop for the outstanding loan. Or the Fed bank can immediately reduce the amount of the loan. The only thing fixed on a TAF loan is the rate. The Fed monitors the collateral on a daily basis. Borrowers that qualified for a loan can un-qualify quickly if the collateral is inadequate.

So you're saying there's nothing to worry about?

There's plenty to worry about, including the collapse of the housing market, early signs of decay in commercial real estate, soaring commodity prices, an over-leveraged consumer, losses and potential capital impairment at financial institutions and an economy that's flat-lining. That's enough to keep you up at night without tossing and turning over the Fed's exposure to credit risk.

(The author is a Bloomberg News columnist. The opinions expressed are her own.)