TAF Results and Banks

Author: David Kotok, Post Date: July 2, 2008

If you look at the most recent reports of the Federal Reserve, you will see that loans and investments in the US banking system are contracting.  Northern Trust’s Paul Kasriel notes that this is the “sharpest 13-week contraction” in the history of this data series.  The Fed’s measure started in 1973.  Contracting credit is an indicator of the deleveraging of the US banking system.

Contracting credit is also a force for deflation, not inflation.  Money expands through the use of credit.  Monetary policy works because of this credit multiplier, which is why a rise in the price level (the true definition of inflation) is achieved through credit expansion.  The reverse is true when credit is contracting.

In the most recent Term Auction Facility (TAF) auction, the Federal Reserve rolled $75 billion in direct-reserve 28-day lending to US banks at an interest rate of 2.34%.  That rate is higher than the Discount Window borrowing rate by 9 basis points (bps).  It is also 33 bps higher than the expected Fed Funds rate over the same period (overnight indexed swap rate, OIX). 

Why did 77 American banks participate in an auction and pay 33 bps above the rate they could pay by borrowing from each other?  Or why did they pay 9 bps above the rate they would pay if they borrowed from the Discount Window (which uses the same collateral as the TAF)?  Answer: the “stigma” of borrowing is still infecting the banking system.

One must conclude that the US banking system is still wounded and the US credit markets are still dysfunctional. They may be less dysfunctional than in previous months when the bid-to-cover ratio of the TAF was higher but they are still not functioning rationally.  What about this relative measure of dysfunction over the last few weeks?  Here the news is not good.  In May there was a TAF auction below the Discount rate.    Now it is above the Discount rate. 

For us to conclude that the US banking system is really mending, we must see repeated auctions of the TAF below the Discount rate.   We are not yet there.

In Europe things appear to be worse when we examine the US dollar-denominated credit sector.   We conclude this by comparing the bidding for the TAF conducted through the European Central Bank (ECB).   Remember, this is a parallel process to our American TAF auctions.

In the US there were 77 banks bidding, submitting $91 billion in bids for $75 billion of available TAF funding.  In Europe the ECB country member banks collectively submitted bids for $85 billion even though that TAF-type facility had only $25 billion of available funding.  Remember that in Europe the banks post collateral with their local national banks.  That collateral is denominated in euros even though the money is actually loaned to them in dollars which are sourced in our Fed.

In other words the demand for TAF-type dollar liquidity in Europe (outside the US jurisdiction) was about the same as the demand inside the US.  We infer that the banking problems in Europe are worsening in terms of US dollar lending and investing.  The ECB bidding was a new record high.  This may also explain why the London Interbank Rate (LIBOR) has been stubbornly above the normal spreads that existed before the credit crisis of the last year commenced.

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