CT16.03 The U.S. Money Market and the Term Auction Facility Case study

IMF Institute for Capacity Development Case Study

Seminar on Chinese Financial Sector Issues T HE U.S.M ONEY M ARKET AND THE T ERM A UCTION F ACILITY:C ASE S TUDY1 Introduction

Since early August 2007, financial markets in the United States and Europe have undergone a sustained period of financial distress, originating from the meltdown of sub-prime mortgage market. During this period of turbulence, short-term financing costs have at times jumped precipitously. For instance, the three-month unsecured Libor spread over the Overnight Inter-bank Swap (OIS) rate, a measure often used to gauge the tension in inter-bank money market, jumped from under 10 basis points in early August 2007 to almost 100 basis points within a month. And in September 2008, following the failures of Lehman Brothers and the American International Group (AIG), it soared from around 100 basis points to a peak of almost 400 basis points in about two weeks (Chart 1). Such strains on the money market quickly spread to other short-term funding markets, e.g., commercial paper (Chart 2). In response to the rapidly deteriorating financial conditions, central banks around the world first resorted to the conventional monetary policy toolbox, which included the Federal Reserve’s efforts in cutting the discount rate and extending the term of loans through the discount window. As it became apparent that conventional tools were not effective enough in addressing the unusual financial distress, the Federal Reserve introduced a new facility, the Term Auction Facility (TAF), to provide liquidity to the market. Some other central banks, such as Bank of Canada, the European Central Bank, and the Swiss National Bank took similar measures to increase lending at longer maturities. Despite these efforts, however, considerable strains in the money market persisted for several months and did not dissipate until spring of 2009.

Liquidity strains and the Federal Reserve’s policy responses

The financial crisis of 2007-2009 has deep roots in the deterioration of sub-prime mortgage market conditions, which began to emerge in late 2006 and early 2007. On February 7, 2007, New Century Financial Corp., the second largest sub-prime mortgage lender in the United States by then, announced a restatement of its 2006 performance from a profit to a substantial loss, which was followed by a number of hedge funds failures and writedowns from investment banks, mainly suffering from the collapse of Mortgage-Backed Securities (MBS) and other related financial derivatives. However, the crisis did not spread to money markets until several months later. On August 9, 2007, the French investment bank BNP halted redemptions from three of its subsidiary mutual funds, and in response to this event, overnight interest rates shot up in European and U.S. money markets.

1 This case study is largely based on Tao Wu (2011), “The U.S. Money Market and the Term Auction Facility in the Financial Crisis of 2007-2009,” Review of Economics and Statistics, Vol. 93 (2), pp. 617-631.

The deterioration of the inter-bank money market conditions had greatly impaired the stability of short-term funding markets and posed severe challenges to central banks’ ability to provide ample liquidity through regular monetary policy channels. Under normal circumstances, the Federal Reserve has two ways to inject liquidity into the market, through open market operations, and by lending at its discount window. However, as explained below, these had not adequately addressed the unusual financial market distress this time.

Open market operations are the most powerful and frequently used policy tool by the Federal Reserve to inject liquidity into market, at a rate close to the target rate set by the Federal Open Market Committee (FOMC). On the open market, the Federal Reserve trades with a selected set of “primary dealers,” through direct purchases or sales of Treasury or government agency securities, or repurchase agreements against such securities. The liquidity is then redistributed by these dealers to other financial institutions in the inter-bank money market, and finally spreads to other sectors of the economy. However, during periods of marked financial turmoil like the one since summer 2007, a heightened reluctance for banks to lend to each other in the inter-bank money market will interrupt this process and can lead to a credit crunch that may substantially slow the overall economy.

The second tool used by the Federal Reserve to supply liquidity is the discount window. Instead of borrowing on the inter-bank money market, sound depository institutions in need of extra liquidity have an alternative to go to the Federal Reserve and obtain funding, through fully collateralized overnight loans, at a rate usually higher than the federal funds rate. From 2003 through the summer of 2007, the discount rate had been maintained at 100 basis points above the federal funds rate target.

In response to the soaring strains in the money market, the Federal Reserve narrowed the discount rate premium, from 100 basis points to 50 basis points on August 17, 2007, immediately after the initial jump in money-market interest rates, and further to 25 basis points on March 17, 2008. The term of loans through the discount window were also extended to up to 30 days in August 2007 and later further extended to 90 days, and such loans were renewable at the request of the borrower. These measures were taken to encourage banks’ borrowing through the discount window. However, their effects was modest, due to the so-called “stigma” problem: during a financial crisis, the banks may be reluctant to borrow from the discount window, worrying that such actions would be interpreted by the market as a sign of their financial weakness, which would reduce their ability to borrow from the market.

As the strains in term funding markets persisted and became particularly elevated in early December 2007, the Federal Reserve introduced a new lending facility, namely, the Term Auction Facility (TAF). With this new facility, the Federal Reserve auctioned a pre-announced amount of credit, twice in each month, to eligible depository institutions that are in solid financial condition, for a term of one month (28 days or 35 days) instead of overnight

(later the term was extended to 85 days in late 2008). The Federal Reserve also established several reciprocal currency swap agreements with the European Central Bank, the Swiss National Bank, the Bank of England, Bank of Japan, and a few other central banks to alleviate dollar liquidity pressures outside the United States.

The TAF accepted the same kind of collateral as the discount window. The amount of the credit was initially set at $20 billion for each auction, and was then gradually increased to $150 billion as of January 2009. In addition, several other new facilities were also created in 2008, for instance, a Term Securities Lending Facility (TSLF) and a Primary Dealer Credit Facility (PDCF), aimed at improving the liquidity conditions of certain types of financial assets. Table 1 compares the main features of some of these new facilities with those of the regular open market operations and the discount window.

Assessment of the TAF’s effectiveness

In the several weeks following the establishment of the TAF on December 12, 2007, credit conditions in the inter-bank market improved substantially. As Chart 1 shows, the three-month Libor spread over the Overnight Inter-bank Swap (OIS) rate dropped sharply from the peak of over 100 basis points in early December of 2007 to around 35 basis points in late January of 2008. However, the spread bounced back in early March 2008 to about 60 basis points and continued to rise, exceeding 80 basis points in mid-April, and, as the financial and macroeconomic conditions rapidly deteriorating in the last few months in 2008, jumped precipitously to almost 400 basis points. The upswing in early spring and the abrupt surge toward the end of 2008 have naturally raised questions about the effectiveness of the TAF in relieving stresses on the money market, and also cast doubts on the effectiveness of other forms of interventions that the Federal Reserve has conducted in the midst of the current financial crisis (Taylor 2009).

During financial turmoil, banks become increasingly reluctant to lend to each other for two reasons. First, counterparty risk or default risk increases as the uncertainty around other banks’ financial conditions rises. Second, banks tend to build up precautionary liquidity as uncertainty about the market value of their own assets (e.g., structured credit products) mounts. Moreover, the cost and availability of funding to keep these structured products on their balance sheet also tightens, and fund managers may also demand extra liquidity readily

available to cover potential redemptions. Heightened counterparty risk and extra liquidity demand lead to an increased unwillingness to lend and likely contributed to the surges in inter-bank interest rates.

By establishing lending facilities that are ready to provide funding to financial institutions in need, the Federal Reserve has sought to relieve the financial strains through several channels. The first and most direct channel is to serve as an additional funding source for banks in immediate need of liquidity, thereby lowering the short-term borrowing costs. Second, because the new facilities reduce pressures on banks to liquidate their assets, these facilities should lessen further upward pressure on their funding costs induced by deterioration in money market conditions. This may contribute to a decline in the counterparty risk, ceteris paribus, and thereby lower risk premiums. Third, with strengthened confidence the investors may ask for less compensation for a given unit of risk, i.e., the risk price may decline in the presence of the TAF. Thus the risk premium, which is the product of risk compensation per unit of risk and the perceived amount of risk, should also decline. Finally, with this additional funding source readily available, there is less demand for banks to excessively hoard liquidity purely from individual precautionary concerns.

So far, most economists and policymakers have generally agreed that the establishment of Term Auction Facility had effectively alleviated financial strains in the inter-bank money market, by relieving liquidity concerns and lowering counterparty default risk premiums. Questions for discussion

Read the case study of “The Mid-2013 ‘money crunch’ in China.” Consider the following questions:

1.What are the similarities and differences between these two scenarios, in terms of

background, triggers, symptoms, and spillovers?

2.What were the policy options faced by each central bank? What different policy tools

did they eventually use, and what were the reasons behind such choices? How are

such differences related to the institutional background including overall financial

market development and each central bank’s operating framework?

3.How quickly were money market strains relieved? How effective were central banks’

communications in these two scenarios?

4.What lessons can policymakers learn from the way these two crises were originated

and handled?

Chart 2: Outstanding Commercial Paper in the United States

(in billions of $, seasonally adjusted )

-0.5

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.04.5

Jan-06A pr-06Jul-06Oct-06Jan-07A pr-07Jul-07Oct-07Jan-08A pr-08Jul-08Oct-08Jan-09Chart 1: Three-Month Libor, Term Fed Funds, and CD-OIS Spreads

3-month Libor-OIS spread

3-month term fed funds-OIS

spread 3-month C D-OIS spread P ercentage points,

annualized

Failure of Lehman Brothers; AIG (Sep. 15-16)G-7 action,Lehman CDS settlement (Oct. 10)TAF established (Dec. 12)TSLF established (Mar. 11)Bear Stearns bailout (Mar. 17)

Sources

Taylor, John B. (2009), “The Threat Posed by Ballooning Federal Reserves,” Financial Times, March 23, 2009.

Wu, Tao (2011), “The U.S. Money Market and the Term Auction Facility in the Financial Crisis of 2007-2009,” Review of Economics and Statistics, Vol. 93 (2), pp. 617-631.