Demand at Fed Auction Seen as Bad Sign
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Banks eagerly gobbled up the loans offered by the Federal Reserve Board through its so-called term auction facility, according to figures released yesterday.
Monday’s auction — whereby banks can trade in their risky assets in exchange for short-term loans from the Fed — showed strong demand, confirming fears of a severe credit shortage and indicating a bleak outlook for the economy.
The Fed offered $20 billion worth of 28-day loans, but received more than $61.55 billion in bids, the agency reported yesterday.
“The larger the total of bids the more severe the liquidity crisis,” the chief economist for Reid Thunberg ICAP, Bob Reid, said. “These numbers represent just one more nail in the coffin of the tight credit environment,” the principal of financial newsletter the Econoclast, Mike Cosgrove, said.
Normally, when a bank faces a liquidity shortage, it simply borrows funds from other banks. In recent months, banks have become increasingly squeamish about lending to each other because they are uncertain of others’ exposure to subprime mortgage-related risk.
“Nobody knows who is holding the poison pills,” Mr. Cosgrove said.
The auction allows the banks to offer up their risky assets, including bonds backed by subprime loans, to the Fed in exchange for liquidity, thereby easing the market’s credit crunch. This will allow the Fed to get reserves into the hands of those banks that need them most.
“What may matter is not the reserves put in the system, nor who gets those reserves, but the troublesome assets temporarily taken off some institutions’ balance sheets,” a professor of economics at the University of California, San Diego, James Hamilton, said.
Similar lending offers have traditionally been available from the Fed through a discount window, a mechanism that allows eligible banks to borrow money from the Fed on a short-term basis. Banks have been historically wary of using this discount window, however, because other banks perceive it as a desperate move to acquire cash by a troubled institution.
Monday’s auction — the first of its kind in America — was held anonymously to prevent it from carrying the same stigma as the discount window. Another $20 billion auction is planned for tomorrow, and two more in January. In fact, there is speculation that this style of Fed auction, which is common practice in Europe, could be held more frequently.
A senior economist for Mesirow Financial, Adolfo Laurenti, said the sizeable demand for Monday’s auction showed the pent-up demand among banks for additional liquidity.
Some economists say this new Fed auction is a positive move. “I think it’s a good idea,” the chief economist at Nomura Securities, David Resler, said. “The Fed is looking for more creative ways to address the liquidity problems that have cropped up from time to time in the money markets, and this seems like a reasonable approach.”
The auction is a “necessary but not sufficient step along the path of restoring ordinary market conditions,” Mr. Laurenti said. “I think the Federal Reserve should think about making this a permanent tool in their set of policy levers.”