The Federal Reserve introduced new lending facilities like the Term Auction Facility, Term Securities Lending Facility, and Primary Dealer Credit Facility to promote liquidity in financial markets during the crisis. These facilities allow banks and dealers to borrow against collateral at auctioned rates. While they have increased liquidity, the Fed still faces risks around moral hazard and controlling inflation if lending standards are not maintained as financial markets stabilize. The success of the Fed's actions depends on restoring confidence without re-inflating asset prices.

1. The Federal Reserve The interaction of new lending facilities – will yields rise? In association with These views are my own and not to be taken as advice under any circumstances Some of the images and all blue highlighted words contain url links to relevant information

2. The New Facilities In addition to Temporary and Permanent Open Market Operations The Federal Reserve introduced new lending and credit facilities to promote liquidity and foster the functioning of financial markets more generally. These measures are in addition to the Fed Discount Window. Term Auction Facility, introduced in December 2007 Term Securities Lending Facility introduced March 2008 Primary Dealer Credit Facility introduced March 2008

3. Term Auction Facility - Background Term Auction Facility Under the Term Auction Facility (TAF), the Federal Reserve will auction term funds to depository institutions. All depository institutions that are eligible to borrow under the primary credit program will be eligible to participate in TAF auctions. All advances must be fully collateralized. Each TAF auction will be for a fixed amount, with the rate determined by the auction process (subject to a minimum bid rate). Bids will be submitted by phone through local Reserve Banks.

4. Term Auction Facility - Operation TAF is designed to allow funds to be auctioned to depository institutions that are eligible to use the primary credit programme. Auctions are held bi-weekly for a fixed amount, with the rate set by the auction process. Since inception TAF limits have increased from $20Bn to $50Bn for each operation. TAF has formalised the lending made using the Temporary Open Market Operations. TAF is liquidity mechanism, allowing collateral to be exchanged for cash.

5. Term Securities Lending Facility - Background Term Securities Lending Facility The Term Securities Lending Facility (TSLF) is a weekly loan facility that promotes liquidity in Treasury and other collateral markets and thus fosters the functioning of financial markets more generally. The program offers Treasury securities held by the System Open Market Account (SOMA) for loan over a one-month term against other program-eligible general collateral. Securities loans are awarded to primary dealers based on a competitive single-price auction.

6. Term Securities Lending Facility - Operation TSLF is a weekly, 28 day rolling facility to allow primary dealers to exchange programme eligible collateral for Treasuries under a bidding process. TSLF uses 2 different collateral pools known as schedule 1 and 2. The Fed can decide, through consultation with primary dealers, which schedule to invoke. TSLF exchanges cannot be repaid early by primary dealers. TSLF is designed to provide liquidity for Treasury Bond demand in the marketplace.

7. Primary Dealer Credit Facility - Background The Federal Reserve has announced that the Federal Reserve Bank of New York has been granted the authority to establish a Primary Dealer Credit Facility (PDCF). This facility is intended to improve the ability of primary dealers to provide financing to participants in securitization markets and promote the orderly functioning of financial markets more generally. Eligible participants include all the primary dealers. They will participate through their clearing banks.

8. Primary Dealer Credit Facility - Operation PDCF is a daily facility that can be rolled without further cost for up to 30 days in any 120 business day period during the life of the programme. Primary dealers initiate a loan by applying through their clearing bank. Loan size is based on the amount of collateral placed. Collateral is priced by the clearing bank. Eligible collateral will include all collateral eligible for tri-party repurchase agreements arranged by the Federal Reserve Open Market Trading Desk, as well as all investment-grade corporate securities, municipal securities, mortgage-backed securities, and asset-backed securities for which a price is available.

9. Is this a liquidity add by the Federal Reserve? Statistical release H.4.1 does show an increase in bank credit not offset fully by reverse repos. However, this may due to the fluctuations in PDCF.

10. Is demand for Treasuries being met? Yields for US Treasuries have moved higher in the past week, especially at the short end. Will the US Treasury market continue to flatten? For comparison the UK gilt curve shows the short end yield falling as the inverted curve over the past year flattens out. Are gilt yields about to fall in a similar pattern to the US?

11. Conclusion It is extremely early in this new environment to judge the effects of the new facilities deployed by the Fed. Whilst there is some evidence that liquidity has expanded, it is not by the amount quoted by many sources. Indeed, the Fed has begun a series of Reverse Repos and Permanent Open Market Operations designed to drain liquidity and/or increase Treasury availability.

12. However, the basic problem for the Fed has not been one of a lack of liquidity, more a lack of ability in the credit markets to operate. With the collapse in confidence in virtually all paper offered as collateral by banks and brokers to enable borrowing, drastic action was required. The Fed facilitated the means to swap lower graded debt for top rate treasuries at reasonable rates. As each new programme has come into existence the type of paper accepted has broadened, in response to the increasing aversion to any type of risk. These actions have given the credit markets and specifically highly leveraged banks and brokers time to address balance sheet issues and to reappraise current risk models. Whilst the contraction of credit is a given as the de-leveraging continues, the Fed has supplied a framework for this to happen in an orderly fashion. Whether the actions taken so far will be enough depends purely on market confidence. If market participants now believe that the Fed will step in and protect positions to the fullest extent, the Fed may be faced with other more serious issues in the medium term.

13. The Fed must accept it has raised the probability that Moral Hazard may stalk the markets, forcing it to make decisions it would rather avoid. Once the step forward was taken to rescue Bear Stearns, the fed implicitly underwrote the whole financial sphere. When the next event occurs and the Fed decides that a “save” isn’t required, markets could react extremely badly. Undoubtedly the Fed should position itself as a watchdog, warning market participants if they are seen to be reviving “animal spirits”. Until the various facilities enabled by the Fed are unwound, the fed should ensure that lending standards remain tight, across the board. A failure to act in such a manner would ignite inflation fears. If bond vigilantes become active it could be extremely difficult for the Fed to control rates. The consequences for the US dollar and the possible destabilising effects on foreign US dollar holdings would threaten the Fed imposed status quo. As we have seen, recent yield curve action is probably welcome to the FOMC, allowing a domestic carry trade for banks and brokers whilst helping to check inflation. The biggest test for the Fed now lies ahead. It must be ready to act, not only to “save” failed entities but also to squash any attempts at re-inflating the credit bubble. To do otherwise would undermine the path the Fed itself has chosen.