The TAF and the Fed's Exposure to Risk

Is the Fed, through it's operation of the Term Auction Facility, bailing out banks and assuming too much risk by accepting financial assets of questionable quality as collateral against loans?

Fed Isn't Getting Snookered by Collateral Risk, by Caroline Baum, Commentary, Bloomberg: Ever since the Federal Reserve created a Term Auction Facility ... to ease the strains in the interbank-lending market, the TAF has been a source of agitation... The thrust ... goes something like this: The Fed, ... printing money at will, is now accepting low-quality collateral as security for 28-day loans to banks whose anonymity is protected. In the process, the central bank assumes credit risk and lays it at the feet of the U.S. taxpayer.

Maybe it's time to take a look at some of the facts.

[Q: Why is the TAF needed?]

[A:]The Fed had already taken steps in August to encourage banks to borrow directly from its discount window... [But...] No matter how nicely the Fed asked, banks were unwilling to incur the stigma associated with discount window borrowing ... at a time when ... any intimation of trouble could cause depositors to take flight. ...

Q: What does a bank have to do to qualify for a loan from the Fed?

A: Banks must be in sound financial condition... They must file the necessary documentation... And they have to pledge collateral...

Q: What sort of securities and loans will be accepted as collateral outside of the traditional U.S. Treasury and agency securities?

A: Corporate and municipal bonds, money-market instruments, asset-backed securities, collateralized-mortgage obligations and various consumer, commercial and industrial, agricultural, residential and commercial real-estate loans.

Q: How does the Fed determine how much to lend against the securities and loans it accepts as collateral?

A: A table of recommended margins for various types of collateral is posted on the Fed's Web site. The Fed lends only a percentage of the market value of the collateral, with the ''haircut'' ranging from 2 percent on short-term, top-quality Treasuries (in other words, the lendable value of a two-year Treasury note is 98 percent) to 40 percent for certain types of consumer loans. ...

If there is no market price for a given security and the discount-window officers and/or bank-supervisory officials at the Fed aren't confident about the value, they can impose a bigger haircut. Alternatively, they can just say no. ...

Q: What happens if the value of the underlying collateral takes a dive during the 28-day term of the loan?

A: The same thing that happens in the private sector: the borrower gets a margin call. If the value of the collateral deteriorates, the Fed can consider other collateral ... Or the Fed bank can immediately reduce the amount of the loan. ... The Fed monitors the collateral on a daily basis. Borrowers that qualified for a loan can un-qualify quickly if the collateral is inadequate.

Q: So you're saying there's nothing to worry about?

A: There's plenty to worry about, including the collapse of the housing market, early signs of decay in commercial real estate, soaring commodity prices, an over-leveraged consumer, losses and potential capital impairment at financial institutions and an economy that's flat-lining. That's enough to keep you up at night without tossing and turning over the Fed's exposure to credit risk.