The Fed Offers More Assistance to Distressed Financial Markets

Today, the Fed also announced an expansion of its securities lending program. Under this new Term Securities Lending Facility (TSLF), the Federal Reserve will lend up to $200 billion of Treasury securities to primary dealers secured for a term of 28 days (rather than overnight, as in the existing program) by a pledge of other securities, including federal agency debt and residential mortgage-backed securities (MBS), as well as non-agency AAA/Aaa-rated, private-label residential MBS. The TSLF is intended to promote liquidity in the financing markets for Treasury and other collateral, and thus to foster the functioning of financial markets more generally. As is the case with the current securities lending program, securities will be made available through an auction process. Auctions will be held on a weekly basis, beginning on March 27, 2008.

This move by the Federal Reserve is intended to address further distress in the functioning of the financial markets, particularly the MBS market. Due to the ongoing recession in the housing market, and accelerating declines in home prices, the valuation of mortgage-backed securities continues to come under downward pressure. This pressure already led to about $150 billion in gross write-offs in the financial system in 2007 (about 15% of banking system capital), but recently this problem has escalated to engulf the highest rated GSE (i.e., Fannie Mae, Freddie Mac, and Ginnie Mae) mortgage-backed securities. Prices on these securities have dropped sharply in the past week, while yields have spiked. At the end of 2007, there was about $4.443 trillion of these GSE mortgage-backed securities outstanding in pools in financial markets, with about $700 billion of that total held in the domestic commercial banking system, and another $700 billion held on balance sheet at the GSEs themselves. A significant chunk of these pools are also held in overseas banks, central banks, and sovereign wealth funds. With the value of these securities now coming under substantial downward pressure, not only does this pose another potential threat to capital levels in the banking system, but investors in general are shunning these securities as a result of further potential mark-to-market write-downs. This has led to the emergence of feedback loops, with significant negative effects for the functioning of the financial markets. With this new action announced on March 11, the Fed is launching a full-scale assault to substantially defuse these feedback loops.

In addition, the Fed announced increases in its existing temporary reciprocal currency arrangements (swap lines) with the European Central Bank (ECB) and the Swiss National Bank (SNB). These arrangements will now provide dollars in amounts up to $30 billion and $6 billion, respectively, to the ECB and the SNB, representing increases of $10 billion and $2 billion. The Federal Open Market Committee extended the term of these swap lines through September 30, 2008. This represents an expansion of the currency swap agreements announced with the same central banks in December 2007. The expansion of the currency swap agreements comes in response to further pressure on U.S. dollar funding costs and U.S. dollar liquidity for banks outside the United States, particularly the banks in Europe. As neither the Swiss National Bank nor the European Central Bank can supply U.S. dollars to the European banks under normal central bank operating conditions, the currency swap agreements are temporary facilities that allow them to provide U.S. dollar funds directly to the European banks, and hence alleviate the U.S. dollar funding pressures that have intensified in European markets.

These latest initiatives are just part of a multi-pronged strategy by the Federal Reserve to combat severe pressures in the financial markets and intensifying recessionary pressures across the economy. The Fed is also expected to lower interest rates aggressively in the next couple of months. Global Insight is forecasting that the FOMC will reduce the federal funds rate by at least 50 basis points on March 18, and by a further 50 basis points in April and June. That would bring the funds rate down to 2.00% by the July-August timeframe.