Should we worry about heavy borrowing from TAF?

How Non-Borrowed Reserves Became a Sexy Subject: Caroline Baum

Commentary by Caroline Baum

Feb. 8 (Bloomberg) -- Technically insolvent! This has never happened before! Without the Temporary Auction Facility, where would banks be?

When I got the fifth hysterical e-mail on the subject of -- sit down -- the decline in banks' non-borrowed reserves, I thought I was back in the Volcker era.

That would be Paul Volcker, chairman of the Federal Reserve from 1979 to 1987. Volcker knew interest rates had to rise significantly to slay the inflation dragon; he didn't know by how much. So he changed the Fed's operating procedure from targeting a price (the overnight interbank lending rate) to a quantity (the monetary aggregates -- specifically non-borrowed reserves).

``There is no relationship between non-borrowed reserves and anything the Fed cares about, be it inflation, employment or real GDP,'' said Paul Kasriel, chief economist at the Northern Trust Corp. in Chicago.

He said that 20 years ago, when I was just starting out, but I still remember his exact words. They came back to me when I learned of the latest obsession with this irrelevant statistic.

A few basics are in order. I promise not to make this too geeky.

Banks are required to keep a certain amount of funds in reserve -- as vault cash or on deposit at the Fed -- to meet unexpected deposit outflows. These are called required reserves (catchy, isn't it?). Sometimes depository institutions elect to hold more than is required. These are called excess reserves.

Sources and Uses

Congratulations. You have just completed the introductory course in the uses of reserves. What about the sources?

Reserves can be borrowed (from the Fed's discount window) or non-borrowed (supplied via the Fed's daily open market operations). It matters not one whit to the Fed where the banks acquire the reserves they require. If they borrow directly from the Fed, they don't need to tap the interbank, or fed funds, market.

What's caused the hullabaloo recently is the dive in non- borrowed reserves from $44 billion in early December to minus $8.8 billion at the end of January.

It isn't a mystery what happened. The Fed announced the creation of a Term Auction Facility on Dec. 12, enabling banks to borrow for 28 days versus a wide range of collateral. The minimum bid the Fed accepts is the expected funds rate one month out, which in the current environment means cheaper funding costs than the fed funds market.

So what would you do if you were a bank?

Lower Cost

Loans made through the TAF are categorized as borrowed reserves. The Fed had $50 billion of loans in place at the end of January, which ``caused the borrowed reserves figure to balloon and the non-borrowed figure to decline by a corresponding amount,'' said Lou Crandall, chief economist at Wrightson ICAP LLC in Jersey City, New Jersey, in a Feb. 6 commentary. (He's on the same e-mail lists I am.)

All of a sudden, people who never glanced at the Fed's H.3 statistical release are now experts on ``Aggregate Reserves of Depository Institutions and the Monetary Base.'' Their e-mails have the same sense of foreboding as the missives put out by the Black Helicopter/Tin-Foil Hat crowd.

``What if the Fed's rate cuts aren't motivated by the desire to stave off recession, rather to prevent a major banking crisis?'' one e-mail read. ``The Fed's not telling anyone what it's up to because it doesn't want to cause panic, but the evidence is there in its own data.'' (Gosh, you'd think it would do a better job of hiding it. Maybe send H.3 to join M3!)

Monopolist Provider

The writer of the e-mail directs his readers to the most recent H.3 report, which shows total reserves ($41.6 billion) less TAF credit ($50 billion) less discount window borrowings ($390 million) equals non-borrowed reserves (minus $8.8 billion). The negative number is really an accounting quirk: If banks borrow more than they need, non-borrowed reserves are a negative number.

This gentleman is overlooking the fact that the Fed is ``a monopoly provider of reserves,'' said Jim Glassman, senior U.S. economist at JPMorgan Chase & Co. ``This is a non-starter. There is no such thing as a banking system short of reserves. The Fed has absolute control over the supply.''

There may be times, such as late last year, when banks are reluctant to lend to one another for a period longer than overnight. ``And any one bank can have a problem'' funding itself, Glassman said. But in a world where ``the Fed can print money, there is no shortage,'' he said. ``The banks get the reserves they want.''

Low Priority Worry

Those hyperventilating over TAF borrowing may want to consider an alternate scenario.

``Suppose the Fed cut the discount rate so that it stood below the funds rate,'' Kasriel said. (He said this yesterday, not two decades ago.) ``Would these folks be upset if banks went to the discount window for funds? What's the difference? It's a difference without a distinction.''

In a commentary this week, Goldman Sachs Group Inc. senior economist Andrew Tilton dismissed the case of the disappearing non-borrowed reserves as ``evidence of the markets' obsession with the health of the financial system.''

Some of the concern is justified, he said, given banks' massive losses and writedowns on subprime loans.

Of all the things to worry about right now, this isn't one of them.

Fed's liquidity strategy to weed off foolish hedge funds and investors

Fed's Strategy of Increasing Liquidity Survives for a Third Day
By Craig Torres

Aug. 22 (Bloomberg) -- The Federal Reserve's strategy of increasing liquidity rather than resorting to a cut in the benchmark interest rate survived a third day.

Yields on Treasury bills rose yesterday after the New York Fed lowered the cost of borrowing securities from its own portfolio to ease a shortage in the market. The action followed a reduction in the Fed's rate on direct loans to banks on Aug. 17, the impact of which officials said they need time to assess.

Chairman Ben S. Bernanke wants to avoid an emergency easing of monetary policy, contrasting with predecessor Alan Greenspan, who cut the federal funds rate target three times in 1998 after the collapse of Long Term Capital Management LP. Richmond Fed Bank President Jeffrey Lacker said yesterday that policy must be guided by the outlook for economic growth and prices, not entirely by markets.

``We did use the fed funds rate and that may have been a mistake,'' said former Fed Vice Chairman Alice Rivlin, who voted for the 1998 rate cuts. ``It might have been smarter to try what they are trying.''

Lacker said in a speech to a conference in Charlotte, North Carolina yesterday that while the credit crunch and gyrations in financial markets has the potential to hurt growth, signs so far indicate business and consumer spending will continue.

In response to a question, Lacker also underscored the Federal Open Market Committee's determination not to insure poor investments with a cut in the federal funds rate.

`Our Responsibility'
``The Federal Reserve isn't responsible for the size of credit spreads,'' he said. ``We leave those to be market determined. Our responsibility and what we are capable of influencing on a sustained basis is inflation and growth.''

After the rate cuts in 1998, the economy strengthened and stock prices soared, Rivlin noted, leaving the Fed open to criticism that the reductions were a mistake. Rivlin is now director of the economic studies program at the Brookings Institution in Washington.

The Fed's current strategy showed some signs of success yesterday as yields on three-month Treasury bills climbed the most since 2000 and those on commercial paper backed by assets such as mortgages slipped.

The three-month bill yield increased 0.52 percentage point to 3.61 percent late yesterday as demand for the shortest-dated government debt waned. Top-rated asset-backed commercial paper maturing in one day yielded 5.92 percent, down from 5.99 percent, posting the first drop in three trading days.

``The flight to safety may be diminishing a bit,'' said Holly Liss, a bond saleswoman in Chicago at Citigroup Global Markets Inc. ``We're seeing more calming of the market as T-bill rates come back to normal.''

Jury Still Out
Lacker said the ``jury is still out'' on whether the Fed has done enough to improve trading in the $1.1 trillion market for asset-backed commercial paper.

Investors and economists still bet that Bernanke will have to reduce the benchmark lending rate between banks, now at 5.25 percent, by at least a quarter point on or before the Sept. 18 meeting.

``Financial volatility and the seizing up of credit markets raises the probability'' of a recession, said Steven Einhorn, vice chairman of New York hedge fund Omega Partners Inc. ``The Fed needs to be proactive and not wait.''

Einhorn said slowing inflation and growth of around 2 percent to 2.5 percent give the Fed room to cut interest rates.

`All of the Tools'
Senate Banking Committee Chairman Christopher Dodd said Bernanke agreed to use ``all of the tools at his disposal'' to restore stability in markets roiled by the subprime mortgage crisis. He added that he didn't ask Bernanke to cut the federal funds rate and that the Fed chief didn't pledge to do so.

Dodd, a Connecticut Democrat who is seeking his party's presidential nomination, said banks should take advantage of lower borrowing costs at the discount window. He spoke after meeting with Bernanke and U.S. Treasury Secretary Henry Paulson.

Yesterday, the New York Fed reduced the so-called minimum fee rate that bond dealers pay to borrow its Treasuries to 0.5 percent from 1 percent.

``We are doing it to provide additional liquidity to the Treasury financing market,'' said Andrew Williams, a spokesman for the New York Fed. He said the rate was the lowest in the history of the program, which has existed in its current form since 1999.

The central bank on Aug. 17 cut the so-called discount rate half a percentage point to 5.75 percent to direct more cash to companies starved for short-term financing while avoiding an emergency reduction in its broader lending-rate target.

Banks can borrow at the discount rate with a wide variety of collateral, including everything from mortgages -- the market that sparked the credit crunch after defaults rose to the highest in five years -- to municipal bonds.

Lacker told risk managers yesterday that the Fed's district banks would even accept boat loans as collateral. It's up to the banks to establish a value for the assets as they make the loan, he said.

Fed Statement

Federal Reserve Release
For immediate release
Release Date: August 17, 2007


Fed Statement:
To promote the restoration of orderly conditions in financial markets, the Federal Reserve Board approved temporary changes to its primary credit discount window facility. The Board approved a 50 basis point reduction in the primary credit rate to 5-3/4 percent, to narrow the spread between the primary credit rate and the Federal Open Market Committee's target federal funds rate to 50 basis points. The Board is also announcing a change to the Reserve Banks' usual practices to allow the provision of term financing for as long as 30 days, renewable by the borrower. These changes will remain in place until the Federal Reserve determines that market liquidity has improved materially. These changes are designed to provide depositories with greater assurance about the cost and availability of funding. The Federal Reserve will continue to accept a broad range of collateral for discount window loans, including home mortgages and related assets. Existing collateral margins will be maintained. In taking this action, the Board approved the requests submitted by the Boards of Directors of the Federal Reserve Banks of New York and San Francisco.

FOMC Statement:
Financial market conditions have deteriorated, and tighter credit conditions and increased uncertainty have the potential to restrain economic growth going forward. In these circumstances, although recent data suggest that the economy has continued to expand at a moderate pace, the Federal Open Market Committee judges that the downside risks to growth have increased appreciably. The Committee is monitoring the situation and is prepared to act as needed to mitigate the adverse effects on the economy arising from the disruptions in financial markets.
Voting in favor of the policy announcement were: Ben S. Bernanke, Chairman; Timothy F. Geithner, Vice Chairman; Richard W. Fisher; Thomas M. Hoenig; Donald L. Kohn; Randall S. Kroszner; Frederic S. Mishkin; Michael H. Moskow; Eric Rosengren; and Kevin M. Warsh.

Federal discount rate cut from 6.25% to 5.75% - Attempt to ease credit crunch in the market

THE FED
Fed cuts discount rate to 5.75%
Central bank's move aimed at easing credit crunch
By Rex Nutting & Mike Maynard, MarketWatch
Last Update: 9:42 AM ET Aug 17, 2007

WASHINGTON (MarketWatch) -- In a move wildly applauded by financial markets on both sides of the Atlantic, the Federal Reserve announced Friday that it's cut the discount rate to 5.75%.
The Federal Reserve Board said it was acting to "promote the restoration of orderly conditions in financial markets."

In a separate statement, the policy-setting Federal Open Market Committee acknowledged the precarious state of credit markets in making the move.

"Financial market conditions have deteriorated, and tighter credit conditions and increased uncertainty have the potential to restrain economic growth," the FOMC said.

Accordingly, the FOMC, led by Fed chairman Ben Bernanke, said it "judges that the downside risks to growth have increased appreciably." Fed officials are "monitoring the situation" and are "prepared to act as needed to mitigate the adverse effects on the economy arising from the disruptions in financial markets," the FOMC said.

U.S. stocks opened much higher.In the bond market, Treasurys weakened.

After last week's meeting, the FOMC had said it judged inflation to be a greater risk to the economy than slow growth.

In effect, the FOMC has shifted its policy bias from tilted toward a rate hike to tilted toward a rate cut.

The discount rate is set by the seven members of the Federal Reserve Board, while the federal funds rate is targeted by the FOMC, which includes all the members of the Fed board, plus five of the 12 regional Fed bank presidents.

While the timing of the Fed's action was a surprise, many investors and analysts had been expecting a rate cut since early August, when growing insolvencies in subprime mortgages sparked fears among investors that other types of credit could also default.

In response, investors began to sell risky securities such as mortgage-backed securities, commercial paper and corporate equities to seek the safety of Treasurys. Even the most qualified borrowers found it difficult and expensive to obtain credit.

The Fed took the "large and unusual" move because of "the plunge in commercial paper" market" and the "increased threat difficult financing conditions pose for viable businesses," wrote Stephen Gallagher, economist for Societe Generale. The Fed's action could provide a temporary alternative to the market for short-term financing needs, Gallagher said.

Worries about a broader impact
The discount rate's the interest rate charged to commercial banks and other depository institutions on loans they receive from regional Federal Reserve lending facilities. It differs from the key federal funds rate, which is the rate at which private institutions lend to other depository institutions overnight.

The discount window is rarely used; only an average of $87 million is borrowed on an average day, said Tony Crescenzi, chief bond market strategist for Miller Tabak & Co.

"It is imperative that the Fed validate this largely symbolic but important action with a cut in the fed funds rate," Crescenzi said.
The target for federal funds remains 5.25%.

Many economists expect the Fed to cut the fed funds rate at the FOMC's next meeting, scheduled for Sept. 18.

By cutting the discount rate instead of the fed funds rate, the Fed signaled that it believes problems are mainly confined to the financial system, and are not yet impacting the broader economy. The cut in the discount rate provides funds to banks but does little to change consumer and commercial interest rates, as a cut in the fed funds rate would do.

The discount rate stood at 6.25% previously; it's been set at one percentage point above the federal funds rate.

Cutting the rate -- something that financial commentators have been agitating for in recent days -- was seen as aimed at narrowing the gap between the discount and fed-funds rates.

The Fed has been providing extra liquidity to the markets on a temporary basis through its open market operations, but had vowed to keep the federal funds targeted at 5.25%.

Since the housing and credit bubble began to unwind, dozens of lenders have gone out of business, several hedge funds have failed and thousands of homes have gone into foreclosure.

The U.S. central bank also announced a change to the Federal Reserve Banks' usual practices designed to allow discount window loans for as long as 30 days, renewable by the borrower, instead of just overnight.

In this way, the Fed said it will be able to keep tabs on market liquidity.

These changes, the Fed said, are expected to afford banks and financial institutions "greater assurance about the cost and availability of funding."

In addition, the Fed will continue to accept a broad range of collateral for discount-window loans, including securities backed by home mortgages and related assets, in line with requests by the boards of directors of the New York Fed and the San Francisco Fed. Existing collateral margins will be maintained as well.