The Fed as lender of first and only resort

October 28, 2008

John KempJohn Kemp is a Reuters columnist. The opinions expressed are his own.

LONDON (Reuters) – The Federal Reserve has unveiled a dizzying array of new lending and liquidity support facilities over the last six weeks, but the diminishing law of marginal returns already looks to have set in. Each new lending and liquidity facility announced by the Fed is providing a smaller boost to confidence than the last.

The market is increasingly focused on how the Treasury and the Fed will fund the ever-expanding array of facilities, and the huge overhang of very short-term paper that needs to be rolled over into longer-term securities in a market that already looks queasy about the forthcoming flood of notes.
Rather than multiplying the number of acronymned facilities further, restoring confidence now rests on solving two issues.

First, the market needs to see buyers for all this new Treasury paper that will have to be issued in the coming year.

The government is under pressure to line up support from overseas central banks and other institutional investors to continue supporting the market by absorbing a large share of the new issuance that will be required.

A much higher share may need to be in the form of Treasury Inflation Protected Securities (TIPS) to reassure buyers the government will not seek to inflate its way out of the problem.

Additional commitments on exchange-rate stability may also need to be given, at least implicity, to solicit strong foreign participation.

Second, the market needs to see that the financial crisis can be contained by a stabilisation of home values, corporate cash flows and default rates.

Until collateral values and default rates stabilise, the steady flow of losses will continue to eat into even the banking system’s supplemented capital base.

The Federal Reserve System’s balance sheet has almost doubled since the start of Sep 2008, as the central bank has created or expanded a dizzying array of new lending facilities providing around $750 billion more support to the commercial banking system.

The chart here (https://customers.reuters.com/d/graphics/US_FEDCND1008.gif) shows the balance sheet expansion — with Fed lending (assets) above the line and sources of funding (liabilities) below.

The Fed is now providing extra credits through the Term Auction Facility ($263 billion); increased primary credits from the discount window ($106 billion); equivalent credits to other primary dealers and broker-dealers ($111 billion); liquidity support to money market mutual funds ($114 billion); and a variety of other uncategorised credit extensions including swap lines ($87 billion); as well as support for JPMorgan’s acquisition of Bear Stearns ($29 billion); and enhanced repo activity ($41 billion).

The Fed has run down its portfolio of Treasury securities as a result of lending operations, swapping them for other less liquid mortgage-backed securities, and has lent out about half of those which remain to securities dealers to provide temporary liquidity (https://customers.reuters.com/d/graphics/US_FDCND1.gif).

The attached graphic is an annotated version of the Fed’s weekly “Statement of Condition” showing the full array of new and enhanced lending and swap facilities (see chart https://customers.reuters.com/d/graphics/FEDBSH1008.mht).

Some of these extra credits have simply remained on deposit or flowed back into the Fed as member banks increased their reserve balances with the central bank.

Excess reserves held with the central bank above the minimum required for operational purposes have risen by around $289 billion in the past twelve months.

But the rest of the Fed’s balance sheet expansion has been funded from the proceeds of a massive US Treasury borrowing programme deposited into a special new account at the central bank.
The Treasury has borrowed $876 billion since the end of Aug (net of refunding).

In the first instance, most of the funding has been raised through the sale of an unprecedented volume of short-term cash management bills in Sep ($320 billion) and Oct ($520 billion).

Only a small proportion has so far been funded through the issue of bills, notes and bonds in the regular series to the public, leaving a massive overhang of debt that will need to be funded at longer maturities in the coming months.

As a result of this huge borrowing programme, the US Treasury now has a staggering $715 billion of cold hard cash and near-equivalents on deposit in various accounts:

(1)  Some $559 billion is on deposit in the Treasury’s new “special supplementary financing programs” account at the Fed to back increased Fed lending and credit facilities to the banking system.

(2)  Another $137 billion is being held in the Treasury’s regular account at the Fed. Presumably this money will eventually be allocated to another account. In the meantime it is a general deposit against which the Fed can lend.

(3)  The Treasury also has $20 billion in its Treasury Tax and Loan (TTL) accounts with commercial banks and had as much as $80 billion in recent days.

The TTL accounts are a holding facility used for surplus Treasury funds which are left with commercial banks for short but fixed maturities to earn commercial rates of interest.

Normally, the Treasury tries to keep balances on both its regular account and the TTL loans to a minimum.
Surpluses are withdrawn to finance spending and reduce borrowing. But in the current climate, the Treasury has no difficulty borrowing overnight.

In fact, it is the only borrower able to do so effectively. So the Treasury is maximising its short term borrowing and depositing the money with the Fed and the commercial banks, in effect doing the borrowing they cannot do for themselves.

The higher than usual balance in the Treasury’s regular Fed account is a form of quiet supplementary support for the central bank.

The higher than usual balances in the TTL facility are a quiet form of support for the banking system.

The problem with all this borrowing is that it is now taking the Treasury perilously close to the statutory debt limit, which was only raised by Congress in July and then again in Oct, as part of the Emergency Economic Stabilisation Act. The statutory debt ceiling currently stands at $11.315 trillion.

The Treasury has already borrowed $876 billion since the end of Aug. Total debt outstanding is now $10.457 trillion, just $858 billion below the revised ceiling.

But the Troubled Assets Recovery Programme (TARP) will require as much as $700 billion worth of borrowing.

It is not clear from the Treasury and Fed accounts whether some of the borrowing already done and the money already deposited into the various accounts is to support the TARP in future. But it looks like those funds are already fully committed backing existing facilities — meaning the Treasury still has to borrow most or all of the TARP funding.

With just $858 billion of unused borrowing authority, and as much as $700 billion of that committed to TARP, the Treasury has just $158 billion of uncommitted borrowing authority left.

A substantial rise in the debt limit is now both inevitable and urgent.

The administration looks set to recall Congress for a special lame-duck session after the Nov elections to approve a further rise in the limit as part of a broader package of financial reform measures and help for homeowners and corporate borrowers designed to stem the rising tide of bankruptcies.

At the time of publication John Kemp did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.

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