Credit Herald

The Federal Reserve’s emergency credit programs have partially revived lending, limiting damage from the credit crisis, without solving the underlying problem of bad assets on bank balance sheets, Deutsche Bank Securities economists said.

With risk premiums still four to five times higher than in mid-2007, prior to the financial crisis, many credit markets are still operating “as if they are on life support,” economists Peter Hooper and Torsten Slok said in a study of the Fed’s programs.

Credit won’t be freely available until policy makers ease fear of financial institution defaults, either by removing bad assets from bank balance sheets, channeling more capital into banks, or both, Slok said in an interview.

“Non-traditional monetary policy has done a lot,” said Slok, a former economist at the International Monetary Fund. “But they have not returned markets to a normal functioning. The Fed alone cannot solve this crisis.”

By doubling its balance sheet during the past year to more than $1.9 trillion, the central bank has reduced the Libor-OIS spread, a measure of banks’ willingness to lend. The gauge, which averaged just 11 basis points from 2001 to July 2007, has fallen to 103 basis points from a record high of 364 basis points after the collapse of Lehman Brothers Holdings Inc. in September.

Major financial institutions have reported losses or writedowns in real estate and derivative assets totaling about $1.2 trillion since the beginning of 2007.

“Money markets remain under considerable stress,” Hooper, a former deputy director of international finance at the Fed, said in an interview.

Borrowing Stigma

The Fed created the Term Auction Facility in December 2007 after an attempt to offer funding to banks through expanded use of the discount window faltered because of the stigma from its use.

Depository institutions could borrow for a fixed period from a pool of money made available biweekly, using the same collateral accepted at the discount window. It “significantly” helped ease banks’ resistance to lend, the study found, lowering the Libor-OIS spread by 3 to 5 basis points after each TAF auction announcement. A basis point is 0.01 percentage point.

“Giving term liquidity was one of the most important things they’ve done,” Slok said.

The TAF concept was extended to so-called primary dealers, institutions that buy and sell securities directly with the Fed, in March 2008.

The Term Securities Lending Facility, TSLF, supplies Treasury securities in exchange for investment-grade securities as collateral. The Primary Dealer Credit Facility, created the same month, offers dealers access to a version of the discount window, providing overnight funding against collateral.

Paring the Spread

Hooper and Slok found that while the TAF “was statistically significant in lowering the Libor-OIS spread,” the two newer programs were not, paring the spread by less than a basis point free credit score online.

Also, the spread between what dealers had to pay for overnight funding using agency mortgage-backed securities instead of Treasuries as collateral initially fell after the programs’ introduction. After Lehman Brothers filed for bankruptcy, though, the spread soared again.

The Fed created several other programs to unclog credit markets after the Lehman failure. To assist companies that used commercial paper to fund ongoing operations, the Fed created the Asset Backed Commercial Paper Money Market Mutual Fund Liquidity Facility, the AMLF, and the Commercial Paper Funding Facility, CPFF, in September and October 2008.

The AMLF, which guarantees the value of asset-backed commercial paper purchased by banks, is perhaps the most successful of the Fed’s programs, the study said.

Bank Purchases

The program has stimulated bank purchases of the assets simply because banks know it’s there. “Market participants view the AMLF as a critical backstop whose diminishing volume belies its importance to market liquidity,” the study said.

The CPFF, a “special purpose vehicle” funded by the Fed that buys high-grade commercial paper, has also been a success, the study said. Non-financial commercial paper issuance is rising again and “market participants view the liquification of the commercial paper market as an important factor relieving pressure” on interest rates.

Early this year the Fed began buying mortgage-backed securities from Fannie Mae and Freddie Mac. That’s helped lower the rate on conforming mortgages, as “the spread to Treasuries has moved significantly lower since the purchases began early in January,” the authors said.

The Fed also established swap facilities with 14 other central banks, giving those banks access to $380 billion to lend to companies in their countries.

‘Major Factor’

The move was “a major factor” in easing foreign credit market pressures post-Lehman, Slok and Hooper said.

Through the Term Asset Backed Securities Loan Facility, the central bank beginning March 25 will provide an initial $200 billion in funding for new AAA-rated auto, student, small business and credit card loans.

The Fed may eventually expand the TALF to $1 trillion and include commercial- and residential-backed mortgage securities.

Still, none of the central bank programs address the insolvency that may result from financial institutions holding bad mortgage assets on their books.

“A final cure is beyond the power of the Fed,” Slok said. “It’s in the hands of the fiscal authorities.”

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