The Fed's new tools (II)

Last week I described the traditional tools of the Fed (open market operations and the discount window) and an old, but less well-known one (repurchase agreements). Then I described the first innovation, the Term Auction Facility, inaugurated in December.

This week I’ll go over the forms of lending introduced in 2008, and then I'll discuss the options that the Fed is rumored to be considering next.

* * *

In 2007 the Federal Reserve made an effort to provide liquidity through channels other than open market operations and repos. To that effect, it created the Term Discount Window Program (TDWP) and the Term Auction Facility (TAF), as I explained last week. Both of those facilities, however, are available only to depository institutions.

So far I’ve been using the ambiguous term “banks” to refer to institutions that borrow funds or buy Treasurys from the Fed. There are however two broad classes of “banks”: depository institutions and primary dealers. Depository institutions are allowed to accept deposits. Primary dealers, on the other hand, are investment banks and brokers that trade in Treasurys with the Federal Reserve. Bear Stearns and Lehman Brothers are two examples in the latter group. As of today, there are 20 of them.

One defining characteristic of depository institutions is that they can use a broad range of assets to secure their loans from the Fed. The discount window, the TDWP and the TAF all accept a set of assets known as “discount collateral.” That includes pretty much all paper of investment quality, including performing sub-prime mortgages. Primary dealers, on the other hand, only have access to open-market operations (OMOs) and repos. The latter only can be obtained after posting General Collateral —that is paper issued by the Treasury or US agencies only.

Following problems in the mortgage and real estate markets last summer, primary dealers found it increasingly hard to obtain short-term financing because nobody would take their suspicious assets as collateral —or would do so only at very high prices. The Fed stepped up to the plate by opening the Term Securities Lending Facility (TSLF) to primary dealers, on March 27. Roughly speaking, a TSLF loan is an exchange of risky securities for Treasuries for 28 days between Federal Reserve and primary dealers. The range of acceptable collateral, although not as wide as at the discount window, includes some types of paper issued by non-agency institutions (AAA/Aaa-rated private label RMBS and CMBS).

To be sure, the Fed has had a securities lending program for a number of years. The novelty of the TSLF is that it extends the range of acceptable collateral beyond Treasuries. A second novelty is that the term of the loans increases from overnight to 28 days.

Unlike the other tools I have discussed, the TSLF does not have an effect on reserve balances by design. This allows the Fed to pursue its recent strategy of providing liquidity to the banking system without increasing the monetary base.

This is what these loans would look like on the balance sheet of the Fed:

Changes in the Fed's balance sheet after a $1,000M TSLF loan
Assets	US government securities	-1,000
	Repurchase agreements	0
	Reverse repurchase agreements	0
	Direct loans	0
	TSLF loan	+1,000
	Other assets	0
Liabilities	Currency in circulation	0
	Reserve balances	0

In March the Fed inaugurated a second form of lending: the Primary Dealer Credit Facility (PDCF). This venue provides overnight cash loans to all primary dealers, at the same interest rate as the discount window does, and by pledging the same type of collateral. With the PDCF the Federal Reserve has de facto opened the discount window to primary dealers.

PDCF loans increase the monetary base (read the FAQ). Because this facility is meant to oil the credit market, not to provide a monetary stimulus, the Fed will continue to offset the increase in reserves using "a number of tools, including, but not necessarily limited to, outright sales of Treasury securities, reverse repurchase agreements, redemptions of Treasury securities, and changes in the sizes of conventional RP transactions." Here's what a PDCF loan looks like, after it has been offset:

Changes in the Fed's balance sheet after a $1,000M PDCF loan, offset by an open market operation
Assets	US government securities	-1,000
	Repurchase agreements	0
	Reverse repurchase agreements	0
	Direct loans	0
	PDCF loan	+1,000
	TSLF loan	0
	Other assets	0
Liabilities	Currency in circulation	-1,000 + 1,000
	Reserve balances	0

The composition of the Fed’s assets has changed substantially over the last nine months. Here’s the balance sheet of the Fed again, in December and March:

Federal Reserve's balance sheet, $ millions
Assets		Aug. 15, 2007	Mar. 19, 2008
	US government securities	789,601	660,484
	Repurchase agreements	24,000	62,000
	Reverse repurchase agreements	-31,941	-46,143
	Term Auction Facility loans	0	80,000
	Primary Dealers Credit Facility	0	28,800
	Direct loans	264	125
	Other assets	37,058	36,603
Liabilities	Currency in circulation	813,085	818,362
	Reserve balances	5,897	3,507

Source: Federal Reserve, H.4.1 release.

With its new tools, the Fed has provided liquidity without printing much money. In a way, the Fed has become a pawnbroker.

The future?

Loans to commercial banks and primary dealers, from one facility or another, represent now a much larger fraction of assets (see chart, from the Wall Street Journal). The fraction of Treasurys has declined to 53% from 87%.