What the Fed is doing with its Term Auction Facility (TAF) is not at all the standard injection of reserves that balloons the money supply. To understand the effects, we need to look at the TAF closely. The following is a first stab at seeing what is going on. We do not know all of what will happen. But we have enough to get an outline.
The banks get a loan of U.S. Treasury bonds from the Fed, a renewable 28-day loan. The Fed becomes a creditor of the bank by making this loan.
The Fed charges the banks a preferentially low interest rate on this loan.
The bank gives the Fed some securities as collateral on the loan, and the Fed gives the U.S. Treasuries in return. The banks sends the Fed debts it owns that are far more risky and far more toxic than Treasuries, such as mortgage-backed securities. Some of it is bad paper, probably a very great deal of it. Its credit rating is misleading, because the credit agencies have failed to downgrade lots of shaky credits.
Some large banks are probably the main beneficiaries. Their asset quality improves while the Fed’s asset quality diminishes. The bank’s financing (its sources of funds, its own liabilities and equity on the right-hand side of its balance sheet) has now changed. The Fed has become a major creditor of the bank.
The Fed has thus partially nationalized these banks. By injecting $200 billion, it has become a major virtual “owner” of the banks. $200 billion is a significant number compared to the net worth (equity) of the banking system, and that number may grow.
The risk borne by the remaining creditors of the banks is reduced, at least temporarily. It is shifted to the Fed. The banks will probably renew these term loans for quite a long time, while the mortgage payments are made. The bank’s equity holders and lenders therefore gain as the assets of the banks improve in quality.
Should these mortgage payments fall short of what the Fed would otherwise have made on the U.S. Treasuries, and that is to be expected, there will be less money to turn over to the U.S. Treasury. (The Fed turns most of its earnings back to the Treasury.) That means that the U.S. taxpayer will end up footing the bill for the bad loans made by the banks.
The Fed is robbing the taxpayer as well as nationalizing the banks covertly.
That is how I see this financial manipulation at this time.1:44 pm on March 11, 2008 Email Michael S. Rozeff