Almost any half-way serious market watcher can tell you that the Federal Reserve has cut its interest rate target by 225 basis points since the ongoing credit crunch began in earnest in mid-2007. Meanwhile, the economy has leaned further toward and possibly into recession while equity markets have fallen sharply over the last six months. Has the Fed done enough with its 225 basis points rate cuts and is more to be expected? Curiously, Fed officials themselves have answered the first part of this question with a resounding “no” but in a manner few expected. The Fed has embarked on an ambitious and comprehensive program to use approaches focused on microeconomics to solve the macroeconomic problem of preventing a possible recession that is largely being fueled by a credit crunch. The latest phase was just announced by the Fed yesterday.

At a minimum, the Fed’s microeconomic approaches to preclude inflation include:

• Easing of terms at the discount window;
• Term Auction Facilities;
• Encouraging mortgage lenders to consider on a case-by-case basis to restructure subprime loans for borrowers that are generally good credit risks;
• Implementing Term Securities Lending Facilities (TSLF) to U.S. primary dealers for the first time; and
• The Fed accepting AAA prime mortgages as collateral.

We are likely to see the Fed expand on these types of liquidity easing programs in the future. But what are the key points of the Fed’s innovations so far?

Easing of terms at the discount window

The first move the Fed made recently to bring in other tools besides just blunt cuts in rates actually occurred in conjunction with an unexpected cut in the discount rate by 50 basis points on August 17, 2007 to 5.75 percent. The Fed also announced that it would accept term financing at the discount window for as long as 30 days, not just overnight.

The Term Auction Facility

On December 12, 2007, the Fed – in a joint effort with the Bank of Canada, the Bank of England, the European Central Bank, and the Swiss National Bank – announced multiple actions to address “elevated pressures in short-term funding markets.” For the Fed, the primary actions were the establishment of a temporary Term Auction Facility and the establishment of foreign exchange swap lines with the European Central Bank and the Swiss National Bank (approved by the Federal Open Market Committee).

The new Term Auction Facility was intended to improve liquidity in the financial markets as the easing of terms at the discount window did not appear to have as large an impact as hoped. Banks seemed to believe that going to the discount window carried too much stigma and once it became public that a bank had gone to the discount window the public might see the bank as weak. 

Under the Term Auction Facility (TAF) program, the Federal Reserve auctions term funds to depository institutions against the wide variety of collateral that can be used to secure loans at the discount window. All depository institutions that are judged to be in generally sound financial condition by their local Reserve Bank and that are eligible to borrow under the primary credit discount window program are eligible to participate in TAF auctions. The TAF increases liquidity in part because the Fed takes some forms of collateral that are not accepted for standard open market operations. Also, the Fed announces the size of the auction in advance and can adjust the size of the auction according to the Fed’s view of what might be needed to alleviate market stress.

The first TAF auction was on December 17 for $20 billion with several TAF auctions following. The Fed decided that the TAF was helping to alleviate some market illiquidity and announced on December 21, 2007 that it would conduct biweekly TAFs  for “as long as necessary to address elevated pressures in short-term funding markets.” The Fed raised the auction amounts to $30 billion in January and February and on March 7 announced that each auction would be raised to $50 billion.

Essentially, the Fed has boosted liquidity in the financial markets by expanding the function of the discount window without the stigma of going to the window. Also, the Fed – by predetermining the auction size – is better able to control the amount of injections into the banking system.

Encouraging mortgage lenders to consider restructuring subprime loans

Possibly the most out-of-the-box approach the Fed is taking to help improve credit markets and preclude recession is its effort to help the private sector rethink subprime loans that companies still hold and are delinquent. On March 4, Federal Reserve Chairman Ben Bernanke spoke on how subprime lenders may be able to help themselves by retooling some subprime loans.

"In cases where refinancing is not possible, the next-best solution may often be some type of loss-mitigation arrangement between the lender and the distressed borrower. Indeed, the Federal Reserve and other regulators have issued guidance urging lenders and servicers to pursue such arrangements as an alternative to foreclosure when feasible and prudent."

As a result of coordinated efforts between the lenders and the public sector, there has been improvement in the mitigation of foreclosures. "We now have more information about the recent pace of loss-mitigation activity than we did just a few months ago, thanks to surveys of servicers by the Mortgage Bankers Association, the Conference of State Bank Supervisors, the Hope Now Alliance, and others. These surveys generally indicate that servicers substantially increased the number of loan workouts in the latter part of last year. The Hope Now Alliance estimates that workouts of subprime mortgages rose from around 250,000 in the third quarter of 2007 to 300,000 in the fourth quarter, while workouts of prime mortgages rose from 150,000 to 175,000 over the same period. The pace of workouts picked up a bit more in January." The micro approach encouraged by the Fed seems to be making a difference.

According to the Fed Chairman, workouts might not just include reducing interest rates for subprime loans but when appropriate could include a write off of some principal if home values have fallen below loan amounts.

The bottom line is that the Fed is going micro behind the scenes to help prevent the macroeconomic problem of possible recession, and the Fed’s suggestions for reworking some subprime loans may be the best example.

Expansion of Fed Term Securities Lending to primary dealers

The Fed announced on March 11 that it is expanding a “Term Securities Lending Facility” (TSLF) to U.S. primary dealers for the first time and will be accepting AAA prime mortgages as collateral.  These and other features of the expansion of this program should improve liquidity in the financial markets, including the mortgage markets. Under this new Term Securities Lending Facility (TSLF), the Federal Reserve will lend up to $200 billion of Treasury securities to primary dealers secured for a term of 28 days (rather than overnight, as in the existing program) by a pledge of other securities, including federal agency debt, federal agency residential-mortgage-backed securities (MBS), and non-agency AAA/Aaa-rated private-label residential MBS. This is the first time that primary dealers are able to participate in such a program. Under TAF, only banking institutions could participate. Auctions will be held on a weekly basis, beginning on March 27, 2008.

With the TSLF program, acceptance by the Fed of certain high quality mortgage-backed securities and federal agency debt as collateral is a big deal. This will help liquefy the mortgage market notably. Also, while mortgage lenders will not directly be able to sell their mortgage-backed securities to the Fed to increase their liquidity, they may be able to do so indirectly if they are able to convince primary dealers to accept their collateral and act as intermediaries in the TSLF.

What’s next?

What’s next for any potential micro approach by the Fed? Many see the next weak spot in the financial markets as being an overextended consumer with too much debt and especially too much high interest consumer debt.  Many banks expanded consumer loans earlier in the decade when the fed funds rate was low. Some consumer credit lenders had issued loans with teaser rates which now have risen. Many also had newly instituted “universal default” clauses in which if a consumer misses a payment to one lender then another lender could use that as a basis for raising its own interest rates for that consumer – in many instances rising to 30 percent annualized. The Fed may already be discussing behind the scenes with banks whether it makes sense for consumer credit lenders to raise rates such that consumers cannot afford to repay loans.

The bottom line

The Fed is still likely to cut the fed funds target rate on March 18 and perhaps again on April 30. But as of this week, the fed funds futures market has eased back a little on its bet that the Fed will cut rates by 75 basis points due to the announcement of the new Term Securities Lending Facility. Without a doubt the Fed is using every tool possible to prevent recession – including microeconomics focused tools. The Bernanke Fed is not just relying on the “helicopter” to get the economy moving again. Chairman Bernanke is sometimes derided by inflation hawks as “Helicopter Ben” for suggesting in some of his earlier academic writings as dumping money to solve recession problems.  Compared to many earlier Fed chairmen, Bernanke appears to be relying on much more complex solutions than just blunt rate cutting.