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Fed’s first foray into unsecured loans.

As per my proposal over a year ago.

Fed’s first foray into unsecured lending

by Krishna Guha
Oct. 6- The Federal Reserve is working with the US Treasury on plans for a dramatic move into unsecured lending in the hope that this extreme step could help bring credit markets back to life.

As well as unsecured lending to banks, this could lead to the Fed directly purchasing commercial paper or funding a special purpose vehicle set up to do this.

Any unsecured lending would be a radical departure for the Fed. Central banks the world over almost never make unsecured loans, and the Fed has never done so in its history.

Wrong, the swap lines to foreign commercial banks seem to me to functionally unsecured lending.

The Fed has loaned over $400 billion on this basis to the ECB so far.

It would allow the Fed to address two key problems in the financial system directly: the freezing of the term interbank money market, which covers all but overnight borrowing, and the rapid contraction of the commercial paper market.

However, the US central bank does not believe it has the legal mandate to make unsecured loans on which there is a reasonable likelihood of some loss. So it needs the Treasury to guarantee losses on the loans, probably under new authorities granted by Congress last week with the passage of the $700bn (€518bn, £402bn) Paulson plan.

The Fed and Treasury are working together on how that might work but were not ready to announce it ­on Monday.

It is awkward for the Treasury to pivot to supporting a big unsecured lending programme when the core of its pitch to Congress was the plan to purchase troubled mortgage-related assets.

There remains some chance that the US authorities are not be able to reach agreement. But the urgency of the situation – and the fact that the Fed referred to unsecured lending in a press release on Monday – suggests that it will happen.

The core of the problem in the interbank market is the lack of availability of term unsecured loans. Banks can get some term funding, but only on a collateralised basis, which helps explain the extreme demand for Treasury securities used for collateral purposes. Unsecured borrowing rates for any significant period of time – such as the three-month Libor (London interbank offered rate) – are sky high. In practice, most financial institutions are now unable to get term loans without collateral, and are funding themselves heavily in the overnight market.

This reliance on overnight money is dangerous for the financial system. It makes banks vulnerable to short-term market dislocations or loss of confidence, increasing the likelihood of failures and firesales of assets.

There are two reasons why banks cannot obtain term unsecured loans from the private market. There is a classic financial-crisis co-ordination problem, characterised as: “I won’t lend you money for a month if I think that everyone else will only lend you money for a day, allowing them to pull out tomorrow and leave me stranded.” This “roll-over” risk is a form of liquidity risk. The second reason is the credit risk of lending to banks, which has been elevated by the financial and economic turmoil .

The Fed’s existing liquidity operations – ramped up again on Monday – reduce liquidity risk by providing a large backstop source of funds. But they are imperfect substitutes for unsecured borrowing, as they are only available on a secured basis. Unsecured term loans – for instance at 100 or 150 basis points over the federal funds rate for three-month money – would provide a near-perfect substitute.

The unsecured Fed term loan rate would act as a ceiling for Libor. Banks would be able to use these loans to reduce their reliance on overnight borrowing, making the system more stable.

Moreover, banks would in theory become more willing to lend spare funds to each other, reviving the private interbank market, since the borrower or lender could turn to the Fed for unsecured loans if it suddenly needed additional liquidity.

The Fed is also actively considering using unsecured lending to shore up the collapsing commercial paper market, in which many corporations as well as financial institutions raise funds.

The US central bank could either buy commercial paper (a form of unsecured debt), or support a special purpose vehicle that would buy this debt with a liquidity line from the Fed and credit support from Treasury.

Another option under consideration is for the Fed to loan money to money market mutual funds to finance their holdings of commercial paper. The Fed is exploring this, but most money funds are wary of leveraging up and worry that this could lead to investors remaining in a fund being exposed to increasing risk. That is why the authorities are having to explore the radical option of buying commercial paper themselves.


8 Responses

  1. Why don’t they just lend to member banks on an unsecured basis where they can regulate capital and assets and eliminate short term interbank lending, which is where the market is frozen. This seems like an obvious solution, why is it not being discussed?

  2. “firesales of assets.” through inflation, and then through deflation, I was hoping to milk the sheeple, are you saying hoarding my wealth to purchase assets on firesale a couple times a generation will no longer be a good warren buffet distressed asset investing strategy? No more big swings for me eh?

    Warren in another life I was a networking engineer, there are bad logistical problems to have a centralized hub like this. The general up in his ivory tower cannot efficiently assess the conditions on the battlefield 3000 miles away as well as the soldier on the ground in the middle of the action – he may think he can – but the general will be wrong. Centralizing all this is going to end badly, then the credit of the US fed will be damaged and scared sheeple will no longer run into the loving arms of big daddy uncle sam and his currency and notes to feel safe – then you gonna have some real problems.

  3. AP-Oct. 7, 2008. Fed to issue 0% interest rate credit cards to consumers. Two cards are available. One features Helicopter Bernanke in Disneyworld hugging Goofy. The second portrays Henry Paulson running the Treasury printing presses.

  4. So all they have to do now is drop the rate to the FF rates, and the prob should be pretty much solved, right?

  5. 1. in the event of loss, some would allocated to the fed vs the fdic. the fed doesn’t want that risk. sad but true. but they might do it anyway as things deteriorate

    2. the banking model only works when the liability side is secure and not used for market discipline, and assets and capital are regulated and supervised.

    3. maybe not until the eurozone gets sorted out if we don’t step up to a $1T fiscal package like my payroll tax holiday

    4. if unsecured lending to member banks in any size is implemented they can even leave the discount rate higher than the funds rate. libor will just be a touch higher

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