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Thursday, April 10, 2008 11:08 AM

Failures of the Term Auction Facility

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The Term Auction Facility (TAF), was supposed to reduce premiums banks charge each other for overnight lending. A new study finds The TAF fails to reduce premiums.

The Federal Reserve's new twice-monthly loan auctions have failed to reduce banks' borrowing costs since officials introduced them in December, Stanford University economist John Taylor said.

There is "no empirical evidence" the Term Auction Facility has reduced the premium that banks charge each other to lend cash for three months, Taylor, author of a monetary-policy formula cited as a benchmark by analysts, wrote in a research paper. San Francisco Fed economist John Williams co-wrote the study, which was posted on the San Francisco Fed's Web site yesterday.
Black Swan In The Money Market

The study, published by the Federal Reserve Bank of San Francisco, is called A Black Swan in the Money Market. It's 36 pages long and not exactly light reading.

The condensed version below consists of 3 charts and 5 paragraphs. The charts show an extremely tight relationship between the Fed Funds Rate and LIBOR (the overnight lending rate between banks) up until August of 2007, but has since exploded. The TAF was supposed to calm things down, but it has not helped. Let's take a look, starting with the charts. The annotations are mine.

click on chart for sharper image

click on chart for sharper image

click on chart for sharper image

Eye of the Hurricane

What's striking to me is the amazing calm before the storm. That decreased volatility was like being in the eye of a hurricane, and somehow not knowing it.

Excerpts from the article ....
Looking at spreads going back to December 2001 illustrates just how unusual this episode has been. The spread on August 9 was 25 basis points above the pre-August 9, 2007 average. That is 7 times the standard deviation before August 9, more than a 6-sigma event. The mean through March 20 was 16 standard deviations above the old mean, which under normality would have been an extraordinarily improbable event.

In an effort to lower the unusual term lending spreads documented above, the Federal Reserve took a number of actions. First it lowered the spread between the discount rate and the fed funds target directly and encouraged more discount window borrowing. But, banks did not increase their borrowing to any large degree. Second, in December 2007, the Federal Reserve established a new facility called the term auction facility (TAF) to provide liquidity directly to financial institutions at a longer duration, and thereby drive down the spread on term lending relative to overnight loans.

According to the Federal Reserve Board, by injecting “term funds through a broader
range of counterparties and against a broader range of collateral than open market
operations, this facility could help ensure that liquidity provisions can be disseminated efficiently even when the unsecured interbank markets are under stress”


In this paper we documented the unusually large spread between term Libor and overnight interest rates in the United States and other money markets beginning on August 9, 2007. We also introduced a financial model to adjust for expectations effects and to test for various explanations that have been offered to explain this unusual development.

The model has two implications. Fist is that counterparty risk is a key factor in explaining the spread between the Libor rate and the OIS rate, and second is that the TAF should not have an effect on the spread. Since the TAF does not affect total liquidity, expectations of future overnight rates, or counterparty risk, the model implies that it will not affect the spread. Our simple econometric tests support both of those implications of our model.
Counterparty Risk Is The Key

The short version of this story is that banks do not trust each other, so they are unwilling to lend to each other except at an unusually wide premium. But why should they trust each other?
Should any of that foster trust?

As long as counterparty risk stays elevated and as long as there is reason to mistrust, there is unlikely to be a huge narrowing in the spread.

What applies to the TAF also applies to the Primary Dealer Credit Facility (PDCF), and the Term Securities Lending Facility (TSLF) as well.

Clearly The Fed Is Terrified and perhaps rightly so. Unfortunately, the Fed by its own actions to encourage more bank to bank lending, is actually fostering an environment of further mistrust that makes it less likely. Instead of encouraging more bank to bank lending, the Fed has simply become a dumping ground for all the garbage mortgage backed securities no one wants to hold.

Mike "Mish" Shedlock
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