Fed Finds New Ways to Inject Funds

MBA (3/12/2008 ) Velz, Orawin
On Tuesday morning, the Federal Reserve announced a new program, the Term Securities Lending Facility (TSLF), in an effort to inject liquidity into the banking system and alleviate the credit-market freeze.
The Fed will lend up to $200 billion in Treasury securities for 28 days to primary dealers. The TSLF will accept mortgage-backed securities as collateral, including federal agency debt, Fannie Mae and Freddie Mac residential mortgage-backed securities (RMBS) and AAA-rated private-label RMBS.

In effect, the Fed will provide financing for an asset class of RMBS under stress, which cannot be financed through the Fed’s regular operations.

“One of the best ways to understand what has been happening in the securitized market since August is to view it as a bank-run without the banks,” said MBA Vice President for Research and Economics Jay Brinkmann. “While the Federal Reserve has long provided the backup liquidity needed for banks, the market seizure since August has demonstrated that the securitized market does not have sufficient liquidity support to keep it functioning in times of stress. The mark-to-market requirements in this environment, combined with fire sale prices, had the effect of creating significant systemic problems. This important and unprecedented step by the Fed should give stability to the market and relieve some of the crisis atmosphere we have seen over the last several days.”

In other news, the trade deficit in goods and services widened by $0.3 billion to $58.2 billion in January, due almost entirely to the increase in the price of imported crude oil. Despite the increase for the month, the deficit is about 14 percent lower than its peak in August of 2006.

For a number of years, the value of imports relative to exports was a drag on economic growth. Starting in the second quarter of 2007, the trade sector turned into a boost to growth. Trade has been a crucial source of economic growth at the time when the decline in home construction and other residential investment has subtracted substantially from growth.

For example, during the fourth quarter, trade contributed 0.9 percentage points to gross domestic product (GDP), while residential investment subtracted one percentage point from GDP. Real GDP grew 0.6 percent (seasonally adjusted annualized rate) during the quarter and would have seen a 0.3 percent decline without the contribution from trade.

The declining dollar has helped improve the deficit because it makes U.S. exports less expensive to foreign consumers, boosting U.S. exports. In addition, strong global economic growth has so far spurred demand for U.S. exports. At the same time, the falling dollar makes U.S. imports more expensive to American consumers, discouraging U.S. imports. Slowing or declining economic growth in the U.S. should continue to restrain U.S. imports going forward; however, record-high crude oil prices will increase the value of imports, limiting improvements in the trade deficit.

The danger of the declining dollar, however, is the inflationary impact of higher import prices and upward pressure on long-term interest rates as foreign investors shun dollar-denominated instruments.

Adjusted for inflation, the real trade deficit widened from $49 billion in December to $49.4 billion, smaller than the average for the fourth quarter of 2007. It is likely that trade will be a contributor to economic growth again in the current quarter.

Credit and recession concerns have roiled the financial markets in recent days. Large financial firms have faced margins calls on their mortgage-backed securities that they are unable to meet, threatening a downward spiral of deleveraging of other firms.

On Monday, Moody's Investors Service downgraded 163 portions of 15 mortgage bonds issued by Bear Stearns Alt-A Trust. Stock markets declined on Monday to the lowest level since 2006, led by concerns that many financial institutions will face increasing losses as the housing downturn deepens.

However, the stock markets rallied following Fed’s move yesterday. As funds moved from the Treasury market to the stock markets, Treasuries’ prices declined and yields increased. The yield on the two-year Treasury jumped 27 basis points to 1.73 percent, the largest increase since 1996. The yield on the 10-year Treasury stayed around 3.60 percent by mid-Tuesday afternoon, 16 basis points higher than the rate on Monday.