Wednesday, October 22, 2008

TAF vs. Discount Window

The Federal Reserve announced $600 billion in new TAF funds on October 7, 2008 to be auctioned in four increments throughout the rest of the year. The Term Auction Facility (TAF) is a new Fed policy tool – one of the 6 added since December 2007, totaling 9 policy tools – and is the Fed’s favorite liquidity measure. Going forward, the TAF is probably here to stay, whereas other new lending facilities – e.g., the Primary Dealer Credit Facility – will be repealed once the credit markets have stabilized. However, I am slightly perplexed by the TAF. On average, it’s terms do not appear to be any more attractive than those at the discount window, so I must conclude that the discount window still has the stigma of “lender of last resort” attached to it.

Why would a bank participate in the TAF auction, rather than borrowing at the discount window?

According to the Fed, here are the stipulations of TAF:
1. The auction allows the Fed to offer funds through a broader range of counterparties (the regional banks, I suppose), while accepting a broader range of collateral (anything other than T bills).
2. The loan matures in either 28 days or 84 (85) days.
3. The stop rate (the interest on the loan) is determined through an auction process.
4. Only banks eligible for primary credit qualify to bid.

The loan terms at the primary discount window and through the TAF auctions are very similar. The primary discount window makes loans (primary getting the better rate) for a term of up to 90 days – same as the TAF in some cases. Only primary credit banks can participate in the TAF auction, where most of the loans made at the discount window are to primary credit banks.

Relative to the size of the discount window ($100 billion as of 10/15/08), TAF lending is massive ($438 billion), and the difference must be accounted for by one of two things: (1) the interest rate for TAF loans must be lower than at the discount window, or (2) the discount window still has the pejorative meaning of “lender of last resort.”

Recently, the Fed took actions to purge discount lending of its negative meaning, so it must be the interest rate.

The chart illustrates the stop-out rate (interest rate on the loan) for the TAF funds and the primary discount rate since the beginning of the year. Since the beginning of the year, there have been 23 TAF auctions with funds ranging from $25 billion to $150 billion, and only 9 times have the auctions resulted in a lower rate than the discount window. And sometimes – 9/22/08 - the auction results in a 150bps spread between the TAF lending rate and the Fed discount rate. The numbers do not indicate that the TAF funds offer a better “deal” than does the discount window

(click to enlarge on image below; Source: Federal Reserve).

I can only conclude that the auction-style of the TAF window offers two incentives over the discount window: (1) the expected stop rate faced by the depository institution is lower than the discount window, and (2) the pejorative “lender of last resort” meaning is not attached to the TAF auction.

Rebecca Wilder

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