$200 billion Term Security Lending Facility is Different from 28 Repo

The move promises to boost liquidity in the MBS market, but at the price of exposing the Fed to credit risk on these securities. It takes the US central bank a step closer to the nuclear option of buying mortgage securities in its own right. “That is the next step,” says Vincent Reinhart, a fellow at the American Enterprise Institute and former chief monetary economist at the Fed. For now, however, the Fed is stopping clearly short of crossing the line into outright purchases. It hopes that by allowing the primary dealers to swap MBS for Treasuries they will ease funding pressures in markets in general and the MBS market in particular. In effect, dealers will be able to park their MBS with the Fed and obtain Treasuries that can in turn be lent out for cash. Senior Fed staffers say this should shore up liquidity in the MBS markets, allowing for better price discovery. That in turn should ease risk spreads on these securities. The new $200bn Term Securities Lending Facility will augment the increased swap lines announced yesterday that will provide $36bn in offshore dollar loans in Europe, and the $200bn in expanded Term Auction Facility (TAF) loans and 28 day repurchase operations announced on Friday. The new securities lending facility will target the primary dealers – providing liquidity to investment banks and other securities houses that cannot access the TAF cash loans. Unlike the 28 day repo, the new facility will accept top-rated private label MBS as well as securities guaranteed by Fannie Mae and Freddie Mac. The new securities lending operation will be the same term as all the other liquidity operations – 28 days. The staffers said they did not extend the term beyond one month because they did not want to displace the private market for longer-term loans, or take on further credit risk. The new operations are still focused on tackling liquidity risk rather than credit risk in the markets. However, the staffers admitted that the central bank was taking on additional credit risk by offering to lend Treasuries in return for triple-A rated MBS for a month at a time. The margin requirements, though not yet fixed, will be more generous than those presently available in the markets. Dealers will be able to roll over their positions with the Fed, which will hold its $200bn portfolio of MBS-backed advances for an indefinite period. The Fed has several layers of protections in place. It will accept only triple-A rated MBS that are not on review for downgrade and will apply a haircut – lending less face value of these securities). Moreover, it will only deal with those primary dealers that it believes represent a low risk. Nonetheless, the fact remains that - taking all the liquidity operations together - the Fed is now taking some credit risk on $436bn in one month advances of cash and securities, about half the total value of its $884bn investment portfolio. Spreads on agency-backed MBS narrowed on Tuesday by about 18 basis points against Treasuries, while the one month Libor/Overnight Index Swap spread was down to 43bp from 56bp the day before. The cost of credit insurance also fell significantly. However, spreads remained far above normal levels, leaving analysts to debate whether the latest efforts would be enough. Dan Alpert, chief executive of Westwood Capital, an investment bank, said: “The move by the Fed today treats the symptoms but not the infection...It does not treat the underlying cause of the symptoms – the unknown magnitude of residential mortgage loan losses.” Experts said the significance of the move could lie in what it signals about the Fed’s willingness to consider still more radical steps if required in the future. Mohammed El Erian, co-chief executive of Pimco, the bond fund manager, said that by deploying its balance sheet more aggressively, the Fed was getting closer to a “regime shift” that could involve the central bank buying MBS directly. This would substitute the unimpaired public sector balance sheet for a contracting private sector balance sheet. The Fed has legal authority to buy agency-backed MBS, though not private label MBS. The US central bank is not there yet. Outright purchases of mortgage securities would expose the Fed to much greater credit risk. The staffers emphasise that it wants to help the market; it does not want to become the market for allocating credit. Before it took such an extreme step, the US central bank could probably expand the size and term of its new lending operations further. But with policymakers appearing increasingly willing to consider all options to try to stop the US falling into a 1990s Japan-style recession – and painfully aware of the limits on the effectiveness of interest rate cuts given higher inflation and expanded risk spreads – direct purchases no longer look unthinkable.