The Fed as Market Maker of Last Resort: better late than never

According to today’s FT: “… the US central bank announced that it would lend primary dealers in the bond market $200bn in Treasury securities for a month at a time and accept ordinary triple-A rated mortgage-backed securities as collateral in return.” … “The latest Fed gambit, announced as a co-ordinated move with other central banks, is designed to improve liquidity by allowing dealers to swap their mortgage-backed securities for Treasuries, which they can in turn use to raise cash.” … “The initiative takes the US central bank a step closer to the nuclear option of buying mortgage-backed securities in its own right, although it stopped well short of such an extreme action.”

The last sentence, of course, is rubbish. The Fed is now accepting non-agency-guaranteed mortgage-backed securities as collateral in exchange for loans of central bank cash. What it is doing is, from an economic perspective, equivalent to doing repos – sale and repurchase operations – (with primary dealers as counterparties) accepting any triple A-rate mortgage-backed securities as collateral. There can be little doubt that the logical next step – the outright purchase by the Fed of non-agency-guaranteed mortgage-backed securities (possibly from a wider range of counterparties than the primary dealers) – won’t be long in coming.

The Fed appears to be trying to obscure this simple reality by splitting the repo into two legs. In the first leg, the Fed lends US Treasuries to the primary dealers, accepting triple A-rated mortgage-backed securities as collateral. There are two key new features to this first leg, the new Term Securities Lending Facility (TSLF). First, the Federal Reserve will lend up to $200 billion of Treasury securities to primary dealers secured for a term of 28 days (rather than overnight, as in the existing program). Second, it will accept as collateral not just federal agency debt and federal agency residential-mortgage-backed securities (MBS), but also non-agency AAA/Aaa-rated private-label RMBS.

In the second leg, the Fed will accept the Treasuries it just lent to the primary dealers as collateral for loans of central bank cash to the primary dealers.

Why make things simple when they can be made complicated? The Fed appears to be embarrassed about doing the right thing – acting as Market Maker of Last Resort (MMLR) by accepting illiquid securities as collateral in repos. By extending both the list of securities eligible as collateral in repos and the maturity of its operations, the Fed is doing what Anne Sibert and I have urged central banks to do since this crisis began ( see (1) (2) (3) and (4) ). All that remains to be done are (1) the extension of the set of eligible counterparties and (2) the conduct of outright purchases of asset-backed securities rather than just their acceptance as collateral in repos.

The old Lender of Last Resort (LoLR) model of providing funding liquidity to solvent but illiquid banks, at a penalty rate and against collateral that would be good in normal times but may have become impaired in disorderly market conditions, may be appropriate in a relationships-based financial system or traditional banking system. It is not capable of dealing with market illiquidity – the kind of liquidity problem likely to arise in a transactions-based model of financial capitalism, that is, a system in which a large share of intermediation occurs through the capital markets rather than through conventional ‘originate and hold’ banks.

In a transactions-based financial system, the Market Maker of Last Resort function complements or even substitutes for the Lender of Last Resort function as the instrument of choice for pursuing financial stability. Rather than disguising the fact that the Fed has woken up to the fact that the world has changed and that central banks have to accept an expanded range of eligible collateral from an expanded range of counterparties when key financial market seize up, the Fed should advertise the fact. They are doing the right thing.

It is key, of course, that the illiquid securities accepted as collateral be valued aggressively and subject to appropriate haircuts to minimize moral hazard. The Bank of England has recruited the services of Paul Klemperer to help it design auctions that will serve as (reservation) price discovery mechanisms, to ensure that the Bank (and behind the Bank the tax payer) do not end up with inadequately collateralised loans. I am sure the Fed must be doing the same with Paul Milgrom and other auction theory geniuses.

The Fed could force some of the effectively unregulated shadow banking sector players into a framework of supervision and regulation, by stipulating that it will deal with a wider range of counterparties than the usual suspects, but only if they are subject to a Fed-approved regulatory and supervisory regime.

In future weeks and months, it is possible that the central banks, including the Fed, will have to move from (multi-stage) repos accepting mortgage-backed securities as collateral to outright open market purchases of mortgage-backed securities and other illiquid private assets, and from an wider range of counterparties.

The emergence of the Fed as a more forceful Market Maker of Last Resort also means that it can go easy on interest rate cuts. As I hold the view that the Federal Funds target rate has already been cut too far, I consider this to be good news indeed. It caps the loss of inflation-fighting credibility the Fed will inevitably suffer as a result of its panicky interest rate escapades since September, without reducing the effectiveness of its market liquidity-oriented financial stability policy.

All that remains is for the private financial institutions, banks and shadow banks, to recognise the losses they have incurred and to scale back their operations or go out of business in a reasonably orderly fashion. The Fed’s readiness to act as Market Maker of Last Resort means that the necessary writing down and writing off of impaired assets and the necessary liquidation of non-viable financial institutions is more likely to take place within a framework of reasonably well-functioning financial and credit markets.

Maverecon: Willem Buiter

Willem Buiter's blog ran until December 2009. This blog is no longer active but it remains open as an archive.

Professor of European Political Economy, London School of Economics and Political Science; former chief economist of the EBRD, former external member of the MPC; adviser to international organisations, governments, central banks and private financial institutions.

Willem Buiter's website