Federal Reserve Creates Term Securities Lending Facility – Market Rallies

| March 12, 2008 | 0 Comments

Yesterday the Dow Jones Industrial Average gained more than 400 points.  It was truly amazing!  I normally don’t encourage people to watch the market minute by minute, but yesterday’s rally was something to behold.  Everything on the screen was green.

Why the rally?

News came out yesterday of a novel way for the Federal Reserve to help with the liquidity crisis.  Over the past few months, in addition to cutting interest rates, the Fed has also been proactive in encouraging banks to borrow funds.  The Fed has injected billions and billions of dollars into the market.  Yesterday they unleashed a new tool that proved to be a very novel idea (but more on that in a minute) .

The nice part about the Federal Reserve announcement is that everyone had the opportunity to rally off the news – even the most downtrodden of stocks.

Freddie Mac (FRE) up 15%
Fannie Mae (FNM) up 11%
Citigroup (C) up 9%
Wells Fargo (WFC) up 10%
Washington Mutual (WM) up 18%
Bank of America (BAC) up 6%

Even the homebuilders got in the action with Toll Brothers (TOL) up 6%, Hovnanian Enterprises (HOV) up 16%, and DR Horton (DHI) up 12%.

Needless to say the “Street” loved the news.

Normally, the Fed changes interest rates and loans money through the Fed Funds window as a way to influence liquidity in the lending markets. In the past, these changes were enough to encourage borrowing and lending – but this time it’s different.

Just so you understand the backdrop.  Banks are required to have a certain amount of money available to meet withdrawal demands.  These liquidity levels are set by the government and help establish the integrity of the bank.

If a bank found they were short of capital, they would pick up the phone and borrow from another big bank (this is an overnight loan).  It was very standard and happened all the time.  These loans could be huge – several billion dollars in size and were always repaid the very next day. But now we have a problem.  Banks don’t trust each other enough to lend money.  Kind of a scary thought.

The banks don’t trust anyone.  Not you, or me, and they certainly don’t trust each other.  (Have you tried to get a loan lately?)  So, why the fear?  Well, if a bank borrows money and then has to write off a loan (think sub-prime mortgages) they might not have enough capital to meet their obligations.  It’s kind of like borrowing money to buy a new car when you’re having problems making the mortgage payment.  The bank that made the loan suddenly has a problem.

It’s a little more complicated, but you get the idea.  Any bank making a loan is really sticking their neck out.  This slowdown in lending is hurting the economy and the Fed needed to act.

So what did the Federal Reserve do that was so novel?

They created a new security . . . a Term Securities Lending Facility (TSLF) and pledged $200 billion to back it.  See, the Fed doesn’t just give money to the banks, they need to supply collateral.  Up till now the banks couldn’t hand over mortgage backed securities.

Mortgage securities like those issued by Freddie Mac and Fannie Mae are being shunned by investors.  The market to trade these securities has dried up.  Now the banks can trade these mortgage securities with the Federal Reserve who will issue Treasury securities, long considered the safest investment in the world.

By the way, these loans are not for the standard overnight timeframe – these TSLFs are good for almost 30 days.  This should take some of the fear out of the banks and increase lending.  This seems like a good solution, but nobody knows if it will work.

How do we make money off of this news?

Simple, this news is great for the markets and many people think it’ll help the banks.  But remember stimulus packages don’t work overnight.  It will take months for the positive impacts to ripple through the economy.

You should view the gains yesterday as a bear market rally.  While it felt good, be prepared for more pain as the markets head lower.  Also keep in mind that the CPI numbers are going to be released on Friday, and that economic news might rain on the parade.

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Category: Bonds

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