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Fed Taffy Pulls And Misdirection Plays

This report is an excerpt from the Wall Street Examiner Professional Edition Daily Fed and Treasury Report originally published in December 2007. To keep up to date with all the machinations of the Fed, Treasury, and foreign central banks in the US market, click here.

The first Taffy pull on 12/17 went off at the lowest accepted rate of 4.65% after starting with a minimum bid set at 4.15%. The total bid was $61.553 billion for the $20 billion offered for a bid to cover ratio of 3.08. There were 93 bidders with an allotment of only 1.96% going at the lowest rate. The Fed left us to wonder what the range and weighted average of the winning bids were. This would be useful information, and it’s interesting that this Fed, which has stressed greater transparency, won’t be providing this information.

A couple of things are notable about this rate. It was 40 basis points above the Fed Funds target, 27 basis points above the rate for AA rated 30 day financial company commercial paper and 50 basis points above the rate for AA rated non-financial paper. It’s also 190 basis points above the rate for 4 week T-bills. No positive carry there. However, the lowest rate accepted of 4.65%, prorated to less than 2% of the bids, was a full 10 basis points below the discount rate. Whoopdedoo!

It would be interesting to know what kinds of collateral were offered. The Fed isn’t kissing and telling. But the data would seem to confirm that there are plenty of depository institutions who are apparently experiencing significant stress. We’ll want to keep an eye on these spreads for each of these auctions for any indication of changes in stress levels.

We had a tipoff that there might be significant interest in the Taffy pull based on a sudden surge in Discount Window borrowings in early December. Those borrowings had been running just a few hundred million a week. The H41 released Thursday 12/13 showed an extraordinary surge in Discount Window (DW) borrowings to $4.5 billion. That rose to $4.76 billion on 12/20. Evidently some banks were having a problem accessing the Fed Funds market. The chart below represents the 4 week average, not what was outstanding at the end of the week. The August surge involved that contrived deal involving the 4 largest US banks, as the Fed tried in vain to attract other borrowers to the DW. This time, it’s for real, and that was confirmed by the $60 billion in bids for the TAF paper.

The second TAF auction, which totaled $20 billion, with a 35 day term, settled Thursday 12/27. The stop out rate was 4.67% but there were fewer bidders than at the prior week’s auction, and the bid to cover dropped to 2.88. 73.4% of the bids were at the stop out rate, although all bidders were awarded that rate. Rather than being an addition of liquidity, the Fed again killed off any positive net addition to the monetary base. It announced on Thursday 12/20 that it would redeem $14 billion of its maturing T-bills on 12/27 the day the TAF credit settled. They also reduced outstanding repos by $2.5 billion more than was needed to offset the remaining $6 billion of Taffy paper settling.

The Fed included this statement in the announcement that it would redeem the T-bills:

The Federal Reserve Open Market Trading Desk will continue to evaluate the need for the use of other tools, including further Treasury bill redemptions, reverse repurchase agreements and Treasury bill sales. (Emphasis added by your editor.)

They have included this statement suggesting additional draining actions in each of the past 3 operating policy announcements since December 3.

On 12/27 they did it again.

On Thursday, January 3, 2008, the Federal Reserve’s System Open Market Account will redeem the full amount of maturing Treasury bill holdings ($12,480,537,000). The Federal Reserve Open Market Trading Desk will continue to evaluate the need for the use of other tools, including further Treasury bill redemptions, reverse repurchase agreements and Treasury bill sales.


I want to emphasize an important difference between the Fed’s normal daily open market operations (OMO), and the TAF auctions. In the case of OMO, the Fed deals only with the 20 primary dealers, all of whom are securities firms who earn the bulk of their income from trading. When the Fed deals in open market operations it is essentially mainlining amphetamines directly into the veins of the market.

The TAF auctions are different in that, while the PDs may certainly be participating, any bank can take part. Instead of lending wholesale to the PDs who then act as a conduit to the rest of the financial system via the mechanism of the market, the Fed is doing an end around direct to the end user banks. The bulk of these funds apparently will be used to shore up weakening balance sheets on a short term basis, and not for speculative trading, as is the norm for the primary dealers. While I will include the Taffies in the SOMA graph, the addition of $20 billion via this route should have far less direct impact on the market than a $20 billion direct injection via standard OMO.

The Fed had announced that it was instituting the Term Auction Facility on Wednesday 12/12:

Under the Term Auction Facility (TAF), the Federal Reserve will auction term funds to depository institutions. All depository institutions that are eligible to borrow under the primary credit program will be eligible to participate in TAF auctions. All advances must be fully collateralized. Each TAF auction will be for a fixed amount, with the rate determined by the auction process (subject to a minimum bid rate). Bids will be submitted by phone through local Reserve Banks.

Needless to day, I assumed that the loans granted under this program would come to be known as Taffies, which only led me to wonder just who the suckers are. The Fed goes on in its press release.

Today, the Bank of Canada, the Bank of England, the European Central Bank, the Federal Reserve, and the Swiss National Bank are announcing measures designed to address elevated pressures in short-term funding markets.

This brought to mind that December 14 was D-Day in Canada. That’s the day the Montreal Accord was due to be settled. For those of you who do not recall, the Montreal Accord was a deal back in August that was forced on holders of the defaulted paper of a failed SIV known as Coventree. The epicenter of the problem is in Quebec, where I have an insider banking contact who is intimately involved with the issue in his capacity as a money market and hedge fund derivatives and credit analyst with a major institution. He tipped me off in July that his institution had not been paid on some Commercial Paper that they had attempted to redeem. A few weeks later, the Canadian business press began reporting on the problem in a limited fashion because it involved some of Quebec’s largest financial institution, most notably National Bank, the sixth largest in Canada, and the Caisse de Depot, the Quebec public employees’ pension fund, which holds some $160 billion in assets (well, it was $160 billion).

The story was that these and other institutions had exposure to limited losses. My contact told me that the potential losses were orders of magnitude larger than was being reported. The Montreal Accord essentially forced the holders of the bad paper to roll it over until October 15 when the deal was supposed to be done to roll some of the paper into a longer term debt security. However, some holders would not agree to the deal because they needed cash. December 14 was then set as the fail safe date for resolution. Obviously, if the paper is bad, no amount of time is going to make a difference, and just as obviously, the paper is bad. So beginning on December 14, some hedge funds are likely to start blowing up, and other major institutions are going to be facing severe problems.

On December 14 the participants in the Montreal Accord announced another 2 week extension. But my contact told me that the major banks that were going to extend short term credit to continue floating the paper were pulling out of the deal, which in essence means that it is falling apart. It looked as though no one will be getting their money back.

However, in late December a final agreement was reached where all the participants agreed to accept long term paper in return for what had been very short term commercial paper. There’s still a question about what they will eventually get back, if anything.

I concluded that the concerted effort of the central banks to provide some kind of broader credit facility at this point in time was NOT a coincidence. The sheet was about to hit the fan.

Actions taken by the Federal Reserve include the establishment of a temporary Term Auction Facility (approved by the Board of Governors of the Federal Reserve System) and the establishment of foreign exchange swap lines with the European Central Bank and the Swiss National Bank (approved by the Federal Open Market Committee). … The Federal Open Market Committee has authorized temporary reciprocal currency arrangements (swap lines) with the European Central Bank (ECB) and the Swiss National Bank (SNB). These arrangements will provide dollars in amounts of up to $20 billion and $4 billion to the ECB and the SNB, respectively, for use in their jurisdictions. The FOMC approved these swap lines for a period of up to six months.

We have discussed the issue of a dollar shortage in Europe as institutions there need to settle dollar denominated debt obligations in dollars and their dollar denominated credits have gone bad. That creates a dollar shortage and extreme pressure in the money markets there, as evidenced by soaring LIBOR rates. The Fed has formalized a method for providing dollars to the ECB for direct injection into the EU banking system. Whether $24 billion will suffice remains to be seen although in the short run there has been some evidence of an easing of pressure as libor rates have dropped over the past week.

Under the Term Auction Facility (TAF) program, the Federal Reserve will auction term funds to depository institutions against the wide variety of collateral that can be used to secure loans at the discount window. All depository institutions that are judged to be in generally sound financial condition by their local Reserve Bank and that are eligible to borrow under the primary credit discount window program will be eligible to participate in TAF auctions. All advances must be fully collateralized. By allowing the Federal Reserve to inject term funds through a broader range of counterparties and against a broader range of collateral than open market operations, this facility could help promote the efficient dissemination of liquidity when the unsecured interbank markets are under stress.

This, I didn’t get. Essentially, the requirements and policies of this program, as well as the intended beneficiaries, are exactly the same as at the Fed’s Discount Window, and nobody was using that facility. How exactly does this differ? What incentive would there be for institutions in “generally sound financial condition” to use this facility if they didn’t need to use the Discount Window in the first place?

Apparently it was the opportunity to borrow at a rate below the discount rate. In the end the difference was 10 basis points. Big deal.

In one respect this was a way for the Fed to go to the Dell “direct to the consumer” model. Normally the Fed pushes liquidity out to the system through its now 20 primary dealers (There had been 21, but Nomura Securities withdrew. Nomura is no more a PD). That worked via the conduit of the markets. Now the Fed has created a means to bypass the PDs and go direct to any bank that wants it. I suppose this would involve some incentive to potential borrowers other than the PDs, many of whom may not need the cash, as evidenced by the difficulty the Fed has had keeping the Fed Funds rate from falling below target recently. But if the smaller banks had been so desperate for funds, why weren’t they at the discount window? The new facility is limited to those in “generally sound financial condition.” That means that for those in desperate straits…..well… too bad.

Each TAF auction will be for a fixed amount, with the rate determined by the auction process (subject to a minimum bid rate). The first TAF auction of $20 billion is scheduled for Monday, December 17, with settlement on Thursday, December 20; this auction will provide 28-day term funds, maturing Thursday, January 17, 2008. The second auction of up to $20 billion is scheduled for Thursday, December 20, with settlement on Thursday, December 27; this auction will provide 35-day funds, maturing Thursday, January 31, 2008. The third and fourth auctions will be held on January 14 and 28, with settlement on the following Thursdays. The amounts of those auctions will be determined in January. The Federal Reserve may conduct additional auctions in subsequent months, depending in part on evolving market conditions.

So they started out with a push of $40 billion. That was a lot of dough in a short time. And even though the Fed usually makes a big injection during this period, this would have been a lot larger than normal. Would the Fed offset some of this with reduced open market operations? I speculated that they would if they wanted to keep Fed Funds trading anywhere near 4.25%. And that is exactly what they did. No new net liquidity was added. In fact, the Fed drained reserves since the first TAF auction on 12/17 through year end.

Depositories will submit bids through their local Reserve Banks. The minimum bid rate for the auctions will be established at the overnight indexed swap (OIS) rate corresponding to the maturity of the credit being auctioned. The OIS rate is a measure of market participants’ expected average federal funds rate over the relevant term. The minimum rate for the December 17 auction along with other auction details will be announced on Friday, December 14. Detailed terms of the auction and summary auction results will be available at

But did the method of setting the minimum bid allow for a rate below the current Fed Funds target? It ostensibly allows the market to set the minimum bid, rather than having it imposed by Fed fiat. At the first auction the lowest bid accepted came in 49 basis points above the minimum bid, but 10 points below the discount rate. That’s not much, considering that 98% of the bids were above the stop out rate of 4.65%.

So we now have something else to track each week. And remember, watch what the do, not what they say.

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