Volume 14, Number 5 July 2008 FEDERAL RESERVE BANK OF NEW YORK Current Issues IN ECONOMICS AND FINANCE www.newyorkfed.org/research/current_issues The Federal Reserve’s Term Auction Facility Olivier Armantier, Sandra Krieger, and James McAndrews As liquidity conditions in the term funding markets grew increasingly strained in late 2007, the Federal Reserve began making funds available directly to banks through a new tool, the Term Auction Facility (TAF). The TAF provides term funding on a collateralized basis, at interest rates and amounts set by auction. The facility is designed to improve liquidity by making it easier for sound institutions to borrow when the markets are not operating efficiently. he Federal Reserve provides reserves almost terparties or their own ability to raise future funds. As a exclusively through its system of domestic open result, banks may have limited access to term funds even if T market operations with a relatively small num- they are willing to pay high interest rates. ber of primary dealers. The operations mainly take the Such a situation emerged in the interbank funding form of repurchase agreements against collateral such as markets in the late summer of 2007, following deteriorat- Treasury, agency, and agency mortgage-backed securities, ing performance in much of the market for mortgage- as well as outright purchases of Treasury securities. When backed securities. Interest rate premiums on unsecured the interbank funding markets run smoothly, the dealers bank funding for one month or longer rose precipitously distribute the reserves to banks, facilitating transactions while the volume of unsecured term funding contracted. in the broader economy. Banks in turn base their willing- The persistence of high term rates kept interest rates ele- ness to lend to one another on their evaluations of the vated on a wide variety of instruments, such as home creditworthiness of their counterparties as well as on their mortgages and corporate loans. Moreover, banks’ increas- own ability to access the funding markets. ing dependence on overnight borrowing contributed to During crisis periods, however, a sudden reduction in higher volatility in overnight interest rates, subjecting the the willingness or ability of banks to distribute reserves institutions to greater uncertainty about funding costs. through interbank transactions can disrupt the funding To improve liquidity in the funding markets, the markets and financial intermediation more broadly. In Federal Reserve made a number of changes to its discount particular, banks of sound credit quality may decide to window facility, a policy tool historically used to provide scale back their “term” lending—lending for periods backup funds to financially sound depository institutions, longer than overnight—to other banks because they are particularly during market disruptions. However, as pres- not as certain of either the creditworthiness of their coun- sure on term funding rates persisted into the fall, the Fed CURRENT ISSUES IN ECONOMICS AND FINANCE VOLUME 14, NUMBER 5 took the new step of auctioning funds directly to depository Chart 1 institutions, by introducing the Term Auction Facility (TAF) LIBOR-OIS Spread in December 2007. Basis points Through the TAF, sound institutions can obtain longer 120 11/28/07 8/9/07 Fed term funding on a collateralized basis through periodic auc- increases 100 size of tions. The new policy tool shares some features of both open TAF market operations and discount window lending. It origi- 80 nates and distributes the lending through auctions of fixed amounts of funds in a fashion similar to open market opera- 60 tions. At the same time, it lends on a collateralized basis by 40 using the discount window and its collateral management operations. What sets the TAF apart from the discount win- 20 Fed announces dow, however, is the competitive auction format and use of a TAF market-determined interest rate. 0 2007:Q1 2007:Q2 2007:Q3 2007:Q4 2008:Q1 April This edition of Current Issues offers a detailed look at the 2008 Term Auction Facility. We discuss the market conditions Sources: Bloomberg L.P.; Board of Governors of the Federal Reserve System. leading up to the facility’s introduction, other funding steps Notes: All rates are for a term of one month. TAF is the Term Auction Facility; LIBOR taken by the Federal Reserve, the central bank’s objectives in is the London Inter-Bank Offered Rate; OIS is the overnight index swap rate. that many firms had been grappling with—uncertainty about the true value of various financial securities created As pressure on term funding rates persisted from residential mortgages—affected the interbank money into the fall, the Fed took the new step of markets in Europe and the United States like a match in a dry forest. A spike occurred in the interest rate on one-month, auctioning funds directly to depository and longer term, interbank loans. This spike is visible in institutions. Chart 1, which shows the spread between term and overnight rates—the first represented by the one-month London Inter- Bank Offered Rate, or LIBOR, and the second by the establishing the TAF, and the structure and operation of the overnight index swap rate, or OIS, calculated as an average of facility. We also describe the results of the first ten TAF auc- expected overnight rates over the term of a one-month tions conducted through April 2008. swap.3 The average spread jumped from 6.4 to 55.4 basis points during the five months following the announcement.4 Market Conditions in 2007 Interest rates on other maturities displayed similar behavior Problems associated with the credit quality of subprime resi - of increased spreads and greater volatility. dential mortgages and structured finance products surfaced Following its steep rise on August 9, the LIBOR-OIS in early 2007.1 Bank funding markets, however, continued to spread peaked in September—reaching its highest point function relatively normally until the August 9 announce- since the 1990 credit crunch.5 After a decline in September ment by BNP Paribas that it could not value assets in three of its investment funds.2 This public statement of a condition 3 LIBOR is an average interbank borrowing rate gathered and published daily by the British Bankers Association. For the U.S. dollar, the British Bankers 1 Structured finance products are instruments such as mortgage-backed secu- Association assembles the interbank borrowing rates from sixteen contributor rities created by pooling underlying mortgages, as well as other instruments panel banks at 11 a.m., looks at the middle eight rates (discarding the top and created to redistribute the risk attributes of underlying streams of income into bottom four), and uses them to calculate an average, which then becomes that a structure that can be parceled out to owners in different ways. day’s LIBOR. An overnight index swap is a fixed/floating interest rate swap 2 BNP’s press release stated that “the complete evaporation of liquidity in certain with the floating leg tied to the daily effective federal funds rate; it measures market segments of the U.S. securitisation market has made it impossible to the expected overnight rates over the term of the swap. When measuring the value certain assets fairly regardless of their quality or credit rating.… In order to relative size of term rates, it is conventional to use the spread between LIBOR protect the interests and ensure the equal treatment of our investors, during these and OIS because it corrects for any expected changes in overnight rates. exceptional times, BNP Paribas Investment Partners has decided to temporarily 4 Source: Bloomberg L.P., OIS-LIBOR one-month spreads for the periods suspend the calculation of the net asset value as well as subscriptions/redemp- January 1, 2007-August 8, 2007, and August 9, 2007-December 31, 2007. tions….” The release can be found at <http://www.bnpparibas.com/en/ journalists/news.asp>. 5 For information on the 1990 credit crunch, see Bernanke and Lown (1991). 2 and October, the spread increased sharply on November 28 funds arising from their prior commitments to supply (the first day on which one-month deposits would extend funds. Overall, the institutions faced a sizable rise in the cur- past year-end) and reached a peak of 110 basis points on rent and expected future demand for funding. December 4. Although we focus on the one-month LIBOR, Lenders in the money markets grew increasingly con- the pattern is very similar across many terms up to a year. cerned, both about the credit risks associated with commer- The fact that term rates were so elevated relative to overnight cial banks and the reduced market liquidity. Their growing funding reveals that banks faced more difficulty borrowing reluctance to lend combined with banks’ heightened funding at all but the shortest terms in fall 2007. needs created a large imbalance between the supply of and Problems linked to structured finance products affected demand for longer term loans. As banks typically account the term money markets because commercial banks had for much of the lending in the short-term money markets, invested in these products through off-balance-sheet enti- ties.6 Banks had provided implicit and explicit guarantees to these entities in case their access to short-term borrow- The market for newly issued securitized ing was curtailed or became too expensive. As investors lost confidence in the streams of income flowing into the struc- credit declined sharply during [fall 2007] tured finance vehicles, they pulled away from investing in and reduced a source of funding to banks them further, and asset-backed commercial paper issuances that originated large amounts of mortgages declined.7 The decline in issuances led to calls on banks’ liq- uidity and credit guarantees; thus, banks had to fund the and other loans.