Is the Fed's desperation finance falling flat?

Posted May 2nd 2008 10:34AM by Peter Cohan
Filed under: Federal Reserve, Recession

Bloomberg News reports that the Fed is increasing its so-called Term Auction Facility (TAF) by 50% to $75 billion. The reason? The program, which makes emergency loans to banks saddled with asset-backed securities (ABS) such as collateralized debt obligations (CDOs), is busted. That's because the TAF is designed to lower borrowing costs but it has accomplished the opposite.

This comes in response to criticism from a Stanford University economist, John Taylor, who wrote in a study last month that there is "no empirical evidence" the TAF has reduced the premium that banks charge each other to lend cash for three months. In fact, last month's TAF auctions were 2.82% and 2.87% -- above the then-2.5% rate on direct loans through the Fed's discount window. This "seeming anomaly" of the higher rate may have resulted from banks' willingness to pay a premium to avoid the stigma of borrowing from the Fed's discount-window.

This means that despite all the happy talk on Wall Street, we are not out of the woods by any stretch of the imagination. As I pointed out here, investment banks and hedge funds borrow $32 for every dollar of capital. If they owned just those dodgy securities, a mere 6% drop in the $6.1 trillion market for CDOs would wipe out their $340 billion worth of capital.

In a nutshell, banks don't have enough capital and the TAF doesn't give it to them -- it's just a short-term shell game. Until the banks write down those CDOs to their true value -- whatever that is -- and raise capital to offset the losses, things remain tough in the capital markets.

Peter Cohan is President of Peter S. Cohan & Associates. He also teaches management at Babson College and edits The Cohan Letter.

Tags: Federal Reserve, FederalReserve, inthenews, TAF, Term Auction Facility, TermAuctionFacility

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Reader Comments (Page 1 of 1)

5-02-2008 @ 12:10PM

David Huston said...

In an interview yesterday, Treasury Secretary Paulson opined that the credit crisis is resolving itself, and, while there's still an uphill struggle, he believes that the worst is over. When are we going to get some transparency and some straight talk about where the banks and investment banks stand, how much the writeoffs are going to be and when, how big a risk are "credit default swaps" to our financial well-being, how many of our financial institutions may not survive their losses, and what's the bill to the taxpayer going to be?