Tuesday, March 2, 2010

Federal Reserve Market Intervention & Its Effects

Make no mistake, while difficult to ascertain the extent and longevity on the outcome, all Federal Reserve interventions affect the markets. The schemes that the FED has employed over the last 18+ months are unique in American history. Frankly, there is no precedent for what they have done. Below is a list of direct market interventions, including the purchases of bonds [Note: the data for this post was obtained from a recent paper published by the OECD and the Federal Reserve Board website.]

1. Asset-Backed Commercial Paper Money Market Fund Liquidity Facility (AMLF): Provided funding to U.S. depository institutions and bank holding companies to finance their purchases of high-quality asset-backed commercial paper (ABCP) from money market mutual funds under certain conditions. The AMLF began operations on September 22, 2008, and was closed on February 1, 2010.

2. Commercial Paper Funding Facility (CPFF): The purpose of the CPFF is to enhance the liquidity of the commercial paper market by increasing the availability of term commercial paper funding to issuers and by providing greater assurance to both issuers and investors that firms will be able to roll over their maturing commercial paper.

3. Money Market Investor Funding Facility (MMIFF): was designed to provide liquidity to U.S. money market investors. Under the MMIFF, the Federal Reserve Bank of New York could provide senior secured funding to a series of special purpose vehicles to facilitate an industry-supported private-sector initiative to finance the purchase of eligible assets from eligible investors. The MMIFF was announced on October 21, 2008, and expired on October 30, 2009.

4. Central Bank Liquidity Swaps: The Federal Reserve entered into agreements to establish temporary reciprocal currency arrangements (central bank liquidity swap lines) with a number of foreign central banks. Two types of temporary swap lines were established: dollar liquidity lines and foreign-currency liquidity lines. The former supplied dollars to foreign central banks while the latter foreign central banks supplied foreign currency to the FED. These temporary arrangements expired on February 1, 2010.

5. Term Auction Facilities (TAF): Under the TAF program, the Federal Reserve auctions term funds to depository institutions. Through the end of 2009, the TAF program made available funds of 28-day and 84-day maturity, at an interest rate that is determined by the auction. On January 27, 2010, the Federal Reserve announced that the final TAF auction will be conducted on March 8, 2010. Term auction credit outstanding is reported in tables 1, 10, and 11 of the H.4.1 statistical release.

6. Primary Dealer Credit Facility (PDCF):
Provides loans of cash and securities to primary dealers, the securities broker-dealers that have a trading relationship with the Federal Reserve Bank of New York. These programs were closed on February 1, 2010. PDCF credit was fully secured by collateral with appropriate haircuts--that is, the value of the collateral exceeded the value of the loan extended.

7. Securities Lending: The FED provided securities loans to primary dealers based on a competitive auction for overnight loans against other Treasury securities as collateral. Securities lent on an overnight basis through this facility are presented in table 1A of the H.4.1 statistical release.

8. Term Securities Lending Facility (TSLF): The TSLF loaned Treasury securities to primary dealers for one month against eligible collateral. The TSLF was closed on February 1, 2010.

9. The Term Securities Lending Facility Options Program (TOP): offered an option to primary dealers to draw upon short-term, fixed rate TSLF loans from the System Open Market Account portfolio in exchange for eligible collateral. Effective July 1, 2009, TOP auctions were suspended and were not resumed before the TSLF program was closed on February 1, 2010.

10. Term Asset-Backed Securities Loan Facility (TALF): The TALF is a funding facility that issues loans with a term of up to five years to holders of eligible asset-backed securities (ABS). On fixed days each month, borrowers will be able to request one or more three-year or, in certain cases, five-year TALF loans. Loan proceeds will be disbursed to the borrower, contingent on receipt by the New York Fed’s custodian bank (custodian) of the eligible collateral, an administrative fee, and margin, if applicable. As the loan is non-recourse, if the borrower does not repay the loan, the New York Fed will enforce its rights in the collateral and sell the collateral to a special purpose vehicle (SPV) established specifically for the purpose of managing such assets. Lending through the TALF is presented in table 1 of the H.4.1 statistical release and is included in "Other loans" in tables 10 and 11. The Federal Reserve Board has authorized extensions of credit through the TALF until June 30, 2010, for loans collateralized by newly issued commercial mortgage-backed securities (CMBS) and through March 31, 2010, for loans collateralized by all other TALF-eligible securities.

11. The agency MBS program will involve the outright purchase of a total of $1.25 trillion in agency MBS by the investment managers on behalf of the Federal Reserve by the end of the first quarter of 2010.

12. Purchased $300 billion longer-dated Treasury Securities (mainly 2-10 year). Completed by the end of October 2009.

13. Purchase about $175 billion in GSE direct obligations, which will be in place through the end of the first quarter of 2010.

Effects of Market Interventions

Although quantifying the effects of asset purchases by central banks remains challenging, the New York Fed has estimated that large-scale asset purchase programs conducted by the Fed taken together (totalling $1.8 trillion) have reduced the 10-year government bond yield as much as 50 basis points.


Interbank Lending Rates

In the mortgage-backed security market in the United States, for instance, the Fed has been the predominant buyer since the introduction of the direct purchase scheme with its acquisition to date exceeding 50% of the total volume of new issuance in 2009.

Conventional Mortgage Rate (30 yrs) – Treasury benchmark bond yield (30 years) = Mortgage spread

Potential Risks

1. Distortionary effects on asset prices may weaken economic performance.

2. Inefficient allocation of money across the financial sector.

3. Unconventional measures if maintained too long can destabilize inflation expectations and induce inflationary pressures.

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