Fed Eyes Move To Unsecured Loans
Tuesday, 07 October, 2008
The Federal Reserve is working with the US Treasury on plans for a dramatic move into unsecured lending in the hope that this extreme step could help bring credit markets back to life.
As well as unsecured lending to banks, this could lead to the Fed directly purchasing commercial paper or funding a special purpose vehicle set up to do this.
Any unsecured lending would be a radical departure for the Fed. Central banks almost never make unsecured loans, and the Fed has never done so in its history.
It would allow the Fed to address two key problems in the financial system directly: the freezing of the term interbank money market, which covers all but overnight borrowing, and the rapid contraction of the commercial paper market.
However, the US central bank does not believe it has the legal mandate to make unsecured loans on which there is a reasonable likelihood of some loss. So it needs the Treasury to guarantee losses on the loans, probably under new authorities granted by Congress last week with the passage of the $700bn (£402bn) Paulson plan.
The Fed and Treasury are working together on how that might work but were not ready to announce it -yesterday. It is awkward for the Treasury to move to supporting a big unsecured lending programmed when the core of its pitch to Congress was the plan to purchase troubled mortgage related assets.
There remains some chance that the US authorities will not be able to reach agreement. But the urgency of the situation - and the fact that the Fed referred to unsecured lending in a press release yesterday - suggests that it will happen.
The core of the problem in the interbank market is the lack of availability of term unsecured loans. Banks can get some term funding, but only on a collateralized basis, which helps explain the extreme demand for Treasury securities used for collateral purposes. Unsecured borrowing rates for any significant period of time - such as the three-month Libor (London interbank offered rate) - are sky high. In practice, most financial institutions are now unable to get term loans without collateral, and are funding themselves heavily in the overnight market.
This reliance on overnight money is dangerous for the financial system. It makes banks vulnerable to short-term market dislocations or loss of confidence, increasing the likelihood of failures and fire sales of assets.
There are two reasons why banks cannot obtain term unsecured loans from the private market. There is a classic financial-crisis coordination problem, characterized as: "I won't lend you money for a month if I think that everyone else will only lend you money for a day, allowing them to pull out tomorrow and leave me stranded." This "roll-over" risk is a form of liquidity risk. The second reason is the credit risk of lending to banks, which has been elevated by the financial and economic turmoil.
The Fed's existing liquidity operations - ramped up again yesterday - reduce liquidity risk by providing a large backstop source of funds. But they are imperfect substitutes for unsecured borrowing, as they are only available on a secured basis. Unsecured term loans - for instance at 100 or 150 basis points over the federal funds rate for three-month money - would provide a near-perfect substitute.
The unsecured Fed term loan rate would act as a ceiling for Libor. Banks would be able to use these loans to reduce their reliance on overnight borrowing, making the system more stable.
Moreover, banks would in theory become more willing to lend spare funds to each other, reviving the private interbank market, since the borrower or lender could turn to the Fed for unsecured loans if it suddenly needed additional liquidity.
Source: http://www.ft.com/
