31 March 2008

The Fed's New Term Securities Auction Facility (TSAF) Explained

pite of the fact that yesterday (Thursday, March 27) was the first day of the Fed's new Term Securities Auction Facility, there was surprisingly little news about how the auction went. I did find this article from the Associated Press, which begins:
WASHINGTON (AP) - Big investment houses took the Federal Reserve up on a first-of-its-kind offer Thursday to let them borrow Treasury securities and put up risky home-loan packages as collateral. It was the latest effort to ease a painful credit crisis.
The whole idea of the TSAF is a little hard to understand, so I came up with this analogy - complete with pictures - to help visualize it:

Instead of talking about abstract concepts like investment houses and mortgage-backed securities, let's substitute something more concrete. Let's say instead of an investment bank, I'm an auto dealer. And instead of an inventory of mortgage-backed securities, I have an inventory of classic cars:

Most people don't appreciate it, but these cars are extremely valuable. After all - they're not making any more '59 Caddies! And based on my very complex, proprietary valuation model, the inventory you see above is worth a cool ten million dollars ($10,000,000).

The only problem is that recently the market for classic cars, like the market for MBS's, has seized up. In fact, if I were to put my inventory on the market, it is likely there would be no bids at all for my fabulous collection. If push came to shove, my collection might only be valued at ten cents on the dollar -- or less -- in a forced fire sale. Ten cents! This is ridiculous, as these assets clearly have value! Check out the tailfins:

The problem is that I need money to run my business. I've got rent to pay, a payroll to meet, inventory to float and bills, bills, bills. I need money! But none of my regular (sane) bankers are interested in doing business with me. That is, no one will loan me enough money so that I can operate. Without money, I'll go out of business. This is also the sad situation that many banks, saddled with inventories of toxic debt, find themselves in.

Luckily, this is where the Fed comes in. The Fed has prepared the TSAF to provide businesses like mine with a "booster shot" - just like the AP article insightfully points out:
The program was announced earlier this month by the Fed and is intended as a booster shot for financial institutions (car dealers like mine in this example) and for the troubled mortgage market (classic car market)...Big Wall Street investment firms (car dealers) can borrow much-in-demand Treasury securities from the Fed and put up more risky investments, including certain shunned mortgage-backed securities (classic car inventories) as collateral for the 28-day loans.
Basically, I can get a 28 day loan of Treasuries - the highest rated securities around. I'll pledge my classic car inventory (junk) to the Fed and in exchange, they'll give me the full value of my inventory - $10,000,000 - in Treasuries. Okay, probably not the full value, but close enough. Maybe the Fed will loan me 95% of the value. Much better than ten cents on the dollar. With these high quality assets on my books, regular banks will no longer be afraid of doing business with me, and will loan me the working capital I need to continue operations.

After 28 days, I'll return the Treasuries to the Fed, plus interest - one third of one percent, according to the article. The Fed will return my classic car inventory. If there are still no bids for my junk when I get it back from the Fed, not to worry. Both the Fed and I will pretend that it is still worth $10,000,000, and we'll do another loan, which will allow me to stay in business for another 28 days. Theoretically, we can keep doing this until the market has bounced back...or something else happens.

That is my honest understanding of how the TSAF works. Crazy world, isn't it?

James Grant, in this excellent interview at Bloomberg, explains what is happening in greater depth. The full interview runs about 15 minutes, and I highly recommend it. Paraphrasing Grant:
The Fed has gotten itself into a new line of work. Previously you could think of the Fed as an immense mutual fund that bought only Treasury securities. Not exactly, but that was kind of asset structure it had.

The Fed is a bank. On the assets side of its balance sheet are mainly Treasury securities. On the liabilities side are Federal Reserve Notes. That was then.

Since December when the Fed started getting into the business of helping to revivify the mortgage market (in our example, the classic car market), the Fed has taken on credit risk. That is to say it has accepted collateral against which it lends Treasury securities … and its collateral is something new and different. It is mortgage backed collateral (junk). The Fed preaches a good game of transparency, but it holds its cards rather close to its chest. We don't know exactly what kind of collateral the Fed is taking. We do know that it is taking new things - mortgage backed things.

Its website will tell you that it is giving these securities a very, very light haircut compared to the kind of discounts that Wall Street firms would take. The Fed, at least according to its website is much less aggressive in marking down the value of them. So one would expect that the banks and brokerage firms seeking accommodation would put forward their less desirable collateral.
In other words, the Fed is giving the best deal around on junk. No one else is buying. But as Grant notes,
The Fed is taking a great big risk with its own reputation and with the standing in the world of the US dollar. The Fed is the institution more than any other that symbolizes the standing of the dollar, such as that standing is these days...
The question is, why oh why is the Fed doing this? Is the Fed that fearful of deflation? That seems to be the standard line. But one thing that I have come to understand about the Fed in recent years that it is predicated upon deception. Look no further than the term of Alan Greenspan, who was the ultimate deceiver, for evidence.

Viewed from this perspective, what is the Fed's ultimate goal? As Grant correctly points out, savers are being decimated by the Fed's policy of low interest rates, high inflation and a weak dollar. But a nation's savings forms the necessary capital base for productive future investment. Capital investment is required for healthy, long term economic growth.

Asked in a different way, why is the Fed intent on destroying the US economy?

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