Thursday, November 27, 2008

Fed as lender and insurer of last resort?

Initially, the Fed had radically relaxed its collateral requirements and permitted using even derivative securities as collateral in its term auction lending windows. But even this failed to have the desired impact, leaving the Government with no option but to make more direct interventions by pumping money directly to revive distressed markets, instruments, and institutions.

On November 25, 2008, the US Treasury and Fed unveiled a facility that will buy up to $200 billion of newly issued, top-rated asset-backed securities. Under this Term Asset Backed Securities Loan Facility (TALF), the Federal Reserve Bank of New York will make one year loans to institutions where the collateral is auto loans, student loans, credit card loans, or business loans guaranteed by the Small Business Administration (all triple AAA rated only). The first $20 billion of lending will come from the TARP, while the remaining will come from the New York Fed, "in effect leveraging each TARP dollar many times over via the Fed’s balance-sheet".

The Fed also promised to buy up to $500 billion-worth of mortgage-backed securities (MBSs) guaranteed by government-sponsored enterprises (GSEs), including the now nationalised mortgage agencies, Fannie Mae and Freddie Mac, and up to $100 billion-worth of their direct debt through auctions.

This marks the emergence of the Fed as a lender of last resort, even effectively lending directly to the homebuyers and taking over the role of the mortgage refinancing agencies itself. It is hoped that this would reduce the credit costs for the big underwriters of home mortgages, which should make it easier and cheaper for people to get mortgages.

There are many dangers associated with such guarantees and loans. At worst, the tax payers will have to pick up the tabs for any loans which get defaulted and any guarantees which have to be made good. The moral hazard concerns generated by it are enormous and we will have to live with it for years to come.

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