TAF, Fallacy of Composition, Report from Singapore

Author: David Kotok, Post Date: July 8, 2008

Our July 2 commentary about the Fed’s Term Auction Facility (TAF) and banks (see: www.cumber.com ) triggered a banker’s response.  He argued that the 9-basis-point premium that banks paid in the latest TAF auction is justified because of the desire of each bank not to be known as one that borrows at the Discount Window.  The banker was confirming the “stigma” that the market attaches to the use of the Window.

Specifically, he wrote:

“Even a bank on the ropes steered clear of the Window.  The potential reputational cost of using the Discount Window far outweighs the financial savings.  Look at the example above.  9 basis points on $75 billion for 28 days is $630,000.  The most one bank can be is 10% of any TAF, so the cost savings of using the Discount Window over TAF for any one bank was a whopping $63,000 (before taxes).  I’ll pass.

“I don’t get the relationship between the current mess and Discount Window stigma.  The stigma has been there through good times and bad.  If banks collectively as a group decide to override the stigma and use the Discount Window, how does that imply we as a group are not wounded and therefore functional?”

The direct answer to the rhetorical question is “It doesn’t.”  Systemic dysfunction is operating in the US regardless of the use of the TAF or the stigmatized Discount Window.  In fact, the banker reinforces my point and leads the conversation to the Fed’s dilemma.

The Fed is trying to overcome what we call the “fallacy of composition.”  That is the term we use to describe a situation where each agent thinks he is acting in his own rational self interest while the collective actions are counterproductive.  A simple metaphor is a fire in a theater.  Each person wants to get out quickly.  If they collectively do so in an orderly way they can all exit safely.  But if they ignore the orderly process, they create a stampede and some of them get hurt.

The Discount Window was designed to be an orderly process where banks could borrow from the Fed when reserves were needed during dysfunctional times.  That characteristic created the stigma.  To try and remove this sign of failure, the Fed actually came out and stated there was no stigma.  Clearly no one believed it. 

The Fed then tried to demonstrate this with a request that certain banks use the Window to show there was no stigma.  Four large banks did use the Window for a short time.  They then withdrew.  So much for the Fed’s request!  That approach failed, too. 

During the recent financial turmoil the Fed has lowered the Discount Window borrowing rate by a greater amount than it lowered the Federal Funds Rate.  And the Fed has liberalized the collateral it will accept.

The collateral for the TAF is the same as that for the Discount Window.  Because of the Window’s stigma, banks still elect not to use it.  Instead they pay a higher rate at the very time the Fed is trying to lower rates in the whole system.

The banker who commented calculated what appears to be a very small cost attached to this fallacy of composition.  In doing so, he fails to see the whole systemic picture.  Interest rates are tiered.  When one key rate (Window) suffers from a “stigma” premium over the Window, the premium is applied as a widening of the tiers in a global system.  The cost of 9 basis points must be calculated on the entire $150 trillion in US dollar debt and derivatives that trade in our global system. This is a huge price ($135 billion annualized) to pay for a stigma that the Fed can easily remove.

The Fed can fix this problem by altering the form of the TAF.  It can lift the 10% restriction at each TAF auction.  And it can make the auction size unlimited.  Essentially the Fed can say that it will loan each member bank all a bank wishes to borrow as long as the bank posts acceptable collateral.  The key is that the Fed maintains the high-quality collateral requirement so that the Fed does not end up with “junk.”

The Fed wants the system to function with sufficient liquidity to clear markets.  And it wants to apply monetary policy, which it can only do when the system is functioning.  An unlimited TAF at the Discount Rate would mean the penalty for borrowing was still 25 basis points over the Federal Funds Rate.  Banks could use the FF market if they so chose.

This way the Fed would be able to better judge if the policy-setting Federal Funds target rate was consistent with the Fed’s outlook for inflation and growth.  The sooner the Fed overcomes the fallacy of composition, the faster it can get back into the business of formulating monetary policy.

At Cumberland we continue to view the financial markets as dysfunctional.  Credit spreads are wider than normal and that is creating both opportunity and risk.  Certain sectors like adjustable-rate preferreds are still nonfunctional.  Banks continue to be plagued with falling housing collateral values and rising delinquencies on home equity loans and other credits.  Commercial credit problems are intensifying.

For fixed income investors that means carefully understanding the structure of bonds and not taking credit quality for granted.  For stock portfolios (ETFs) some cash reserves are warranted, as there may be future buying opportunities available in these struggling markets.

And for the Fed, it means more and longer term application of the important new tools the Fed has deployed to restore liquidity and functionality to these very troubled markets.

A personal note: we write this from Singapore after a whirlwind series of meetings with bankers, foreign exchange traders, investors, money and wealth managers and institutional policy makers.  It is apparent to this writer that the view of the US from this regional financial center is highly skeptical.  The US dollar is not trusted and the US government’s policy apparatus is seen as damaged if not broken.  There is an underlying theme of conversation about diversification out of the dollar.  And there are many questions posed about the economic outlook in the US.  I will have more observations to share as time permits.  Readers may see some of the clips from our CNBC Squawk Box Asia guest hosting by searching under “Kotok” at CNBC.com.  We are scheduled for another interview on Worldwide Exchange at 5:30 AM New York time on Wednesday morning, July 9.

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