Banking is one of our economy's most important players, financing the aspirations of everyone from homeowners to private-equity titans. Since last summer, the weakening collateralized debt market has mired the banking industry in one of the stickiest spots it's seen in decades. So when Fed chairman Ben Bernanke was faced with the possibility that panic in the banking industry might turn an ugly problem into an outright catastrophe, he sprung into action in ways we've never seen.
A bit of background
Banks must keep specific amounts of cash on hand, called required reserves, to ensure that they can meet customers' withdrawal requirements. Money flows in and out every day at different levels, so when some banks fall behind, those with deeper pockets loan money out and cover the difference. Bank of America (NYSE: BAC ) can lend to Washington Mutual (NYSE: WM ) , JPMorgan (NYSE: JPM ) can cover Wachovia (NYSE: WB ) , and so on, until everyone is squared up at the end of the day. It's like the corporate version of a hippie commune.
But when money gets really tight, and lending between banks falls short, the Fed steps in and acts as a lender of last resort. It loans banks money through what it calls the discount window, albeit at a higher rate than banks charge each other. It really is last resort, because relying on the Fed for money is the equivalent of asking your parents for a loan; it doesn't exactly instill confidence in your financial well-being.
Uncle Ben to the rescue!
When banks hit a logjam in December, Bernanke faced quite a bind. Interbank lending slowed as market uncertainly grew, yet banks were reluctant to use the discount window, for fear that the banking industry's health as a whole would be called into question. Their options were running low. Bernanke's solution: the term auction facility.
The term auction facility, or TAF, isn't too different than the standard discount window. It just allows the Fed to lend predetermined amounts of money, and let the banks bid on the interest rate. Most importantly, it doesn't come with the stigma of the discount window, which threatened further panic.
The Fed wasn't shy about how much money it was willing to front. A recent article in the Financial Times revealed that banks borrowed around $50 billion from the TAF as of mid-February. That's a lot of money, even for big banks. The latest round of loans, earlier this month, totaled $30 billion at 3%.
That 3% number is quite peculiar. It's the same amount as the Federal Funds Rate -- the rate at which banks lend to one another -- but lower than the discount rate the Fed would typically charge.
It's all coming together
Waaaait a minute. If the TAF and the Fed Funds rate are identical, why aren't banks just lending to each other, like they always do? The TAF isn't saving banks any money over the interbank market, so why the hassle?
For one thing, the TAF lets banks use their battered CDOs as collateral against loans that would get laughed out of the interbank market. Perhaps banks have cut back lending to each other because they know that their fellow banks' CDO collateral is much like their own: impossible to accurately value.
When participants in the private interbank market refuse to lend to each other because they know the collateral backing those loans is questionable, what does that say about the Fed? Sure, the money is being "loaned," and you can call it "adding liquidity." But when the Fed takes on risk for a price the private market doesn't deem adequate, you're looking at a government bailout.
Shhh! Don't awake the sleeping giant
Since last fall, banks like Citigroup (NYSE: C ) and Bear Stearns (NYSE: BSC ) have announced numerous bailouts from Sovereign Wealth Funds. Just weeks ago, President Bush signed into law a government stimulus package to bolster the economy. While these actions have been heavily publicized, the TAF remains behind the scenes. What gives?
Regardless of how overblown real estate values became, a large part of the breakdown in debt markets stems from investors' lack of confidence. Just as jubilation pushed CDOs to astronomical heights, fear could just as easily push them down to laughably low depths. Emotions often overrule even the most obvious statistics, and Bernanke hardly wants to inject the market with more fear than it already contains.
By using the TAF, Bernanke was able prevent added panic and simultaneously keep the banking system sound. Nonetheless, he -- and hence, the general public -- swallowed the risk banks had built up over the years. Did he do the right thing? I certainly think so; it's scary to think where banks would be today without such measures. All the same, actions like Bernanke's only shed further light on how wobbly the banking sector has become.
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