Primary Dealers Credit Facility: Changes for Market Liquidity

I. Introduction

On March 17, 2008, Bear Stearns, one of the oldest and largest global investment firms on Wall Street unexpectedly collapsed and was sold to J.P. Morgan Chase & Co at a fire-sale price of $2 a share in stock, approximately $236 million.[1]  With the rumors about Bear Stearns' losses in the mortgage industry circulating in the market, investors pulled their money out, the firm was short on cash, and the deepening losses left Bear Stearns with no other choice but to sell to their white knight, J.P. Morgan Chase & Co.[2]  With the help of the Federal Reserve, the acquisition price was later revised to approximately $10 per share, totaling $1 billion; however, even the revised deal was still much lower than the company's value of $20 billion in January 2007.[3]

In response to the ongoing credit crisis and the sudden crash of Bear Stearns, the Federal Reserve ("Fed") took several measures to help ease the market.  Wanting to ensure that other investment banks can avoid a crash like Bear Stearns, on March 16, 2008, the Fed Board of Governors announced a new loan program and established the "Primary Dealer Credit Facility"  ("PDCF").[4] This new program is designed to help struggling investment banks avoid a liquidity crisis.[5] 

II. Primary Dealers Credit Facility: What is it and what purpose does it serve?

The PDCF is a new lending facility established by the Fed for the newly launched loan program.  The program allows the biggest twenty securities dealers, the primary dealers in the market, to temporarily obtain emergency loans and borrow money directly from the central bank, similar to the discount windows available to commercial banks.[6]  The Fed acts as a lender of last resort and lends overnight loans to the investment companies at a low interest rate of 2.5%.[7]  This program is the broadest use of the Fed's lending authority since the 1930s.[8]  The Fed initially planned to have the PDCF placed for at least six months, but there may be an extension depending on the conditions of the market.[9] 

Through the PDCF, emergency loans are available everyday.  The primary purpose of the program is to provide funding to individual dealers that are unable to fund its holding of securities in the broader repurchase (“repo”) market.[10]  Poor liquidity in trading particular classes of securities creates the impairment to fund securities in the repo market and this ultimately prevents investment companies from using these securities as collateral.[11]  The PDCF will effectively provide temporary financing for collateral in the repo market in exchange for the Wall Street firms submission of their hard-to-trade-securities.[12]  Later, the investment banks that submitted these hard-to-trade-securities will buy them back at a higher price usually the next day.[13]  The overall objective of the new program is to improve market liquidity, encourage primary dealers to be more inclined to lend to each other, and to provide relief to the distressed market for mortgage-linked securities.[14]   

III. The Fed's Programs and Potential Problems

Within the first three days, the PDCF provided an average daily borrowing of $31.3 billions to investment firms.[15]  Earlier in April the lending hit a high of $38 billion, but now the amount of loans have gradually declined.[16]  The week ending on April 16, the daily borrowing through the lending program averaged approximately  $24.804 billion.[17] 

In addition, the Fed has also been auctioning super-safe Treasury securities to big investment banks through the Term Auction Facility.[18] As of April 17, 2008, there have been four auctions and on the fourth, the Fed auctioned another $24.999 billion securities where the bidders paid an interest of 0.1% and the Fed received bids of $35.1 billion worth of securities.[19] The auction program is intended to help financial institutions and the troubled mortgage market.[20]  Since the Fed has sold or lent Treasury securities, the total securities auctioned amount to $300 billion, and the Fed stated that it will continue to make as much as $200 billion worth of Treasury securities available through weekly auctions.[21]  The Fed has taken large measures to ease the market through changes of monetary policy and assist in increasing market liquidity by putting new programs and facilities in place, but there may be some potential for unwanted consequences.   

Currently, some expert are recommending that the Treasury borrow more money than the government needs, then to take the excess and leave the remaining proceeds on deposit at the Fed.[22]  There has also been some talk about issuing debt under the Fed's name rather than the Treasury's.[23]  It can be argued that these additional recommendations were made because the current "solutions" to the recent credit crunch are insufficient in benefiting the market in the long-run.  The lowered interest rates, changes in monetary policy, and the creation of the PCDF are in reality, "quick fixes" to the crisis not long-term solutions for the market.  Allowing investment banks to rely on the Fed as a bailout may provide relief for some big investment banks on Wall Street for now, but for the Fed there is growing pressure to keep the funds coming.   Before the credit crunch in August, the Fed had $790 billion in Treasury securities on its balance sheet, about 87% of its total assets;  however, since the crunch, the balance has decreased to $490 billion over the last eight months.[24]  With investment houses borrowing left and right, the Fed like any other central bank could fall short on funds if the current crisis continues to escalate.  It is also true that the Fed,  like any other central banks, can easily print out more money if they find themselves in trouble; however, as easy as it sounds, there are consequences for such actions.[25]  With more printing comes inflation and lower interest rates for short-term loans.[26] 

IV. Conclusion

Since the market crisis began in August it has been a struggle for all.  The Fed acted quickly to bring some assist the depressed market including lowering interest rates, federal fund's rates, and establishing the PCDF, and creating other facilities like the Term Auction Facility and discount windows hoping to ease the market.  These measures have provided more liquidity for the market now, but there is no knowing how long the benefits and the funds will last.  The Fed has more or less implemented "quick fixes" but have not proposed long-term changes that could potentially prevent and deal with future market problems. More permanent provisions should be implemented for a more stable future.

Sources:

[1] Robin Sidel, Dennis K. Berman & Kate Kelly, J.P. Morgan Buys Bear in Fire Sale, As Fed Widens Credit to Avert Crisis, WALL STREET J., Mar.17, 2008, at A1, available at http://online.wsj.com/article/SB120569598608739825.html

[2] Id.

[3] Andrew Ross Sorkin, J.P. Morgan Raises Bid for Bear Stearns to $10 a Share, NY TIMES, Mar. 24, 2008, available at http://www.nytimes.com/2008/03/24/business/24deal-web.html?pagewanted=print

[4] Understanding the Recent Changes to Federal Reserve Liquidity Provision, Federal Reserve Bank of New York, http://www.newyorkfed.org/markets/Understanding_Fed_Lending.html (last visited Apr. 19, 2008)

[5] Investment Houses Tap Fed for Billions in Emergency Loans, ASSOCIATED PRESS(FOX BUSINESS), Apr. 3, 2008, available at http://www.foxbusiness.com/markets/industries/government/article/investment-houses-tap-fed-billions-emergency-loans_548527_18.html?referer=sphere_related_content&referer=sphere_related_content

[6] Id.

[7] Id.

[8] Sudeep Reddy, Wall Street Taps Fed's New Loan Program, WALL STREET J., Mar. 21, 2008, at A3, available at http://online.wsj.com/article/SB120604493786952747.html?mod=hps_us_whats_news

[9] Id.

[10] Understanding the Recent Changes to Federal Reserve Liquidity Provision, supra note 4

[11] Id.

[12] Id.

[13] Id.

[14] Reddy, supra note 9

[15] Update: Primary Dealers Cut Borrowing at Fed Credit Facility, FOREX MARKET, Apr. 17, 2008, available at http://www.fxstreet.com/news/forex-news/article.aspx?StoryId=a30432cd-65a0-4b45-9fe3-92b0af069c6c

[16] Id.

[17] Investment Houses Tap Fed for Billions in Emergency Loans, supra note 6.

[18] Id.

[19] Fed Auctions $25B in Treasury Securities, CNN MONEY, Apr. 17, 2008, available at http://money.cnn.com/2008/04/17/news/economy/Fed_auction.ap/index.htm?section=money_latest&referer=sphere_related_content&referer=sphere_related_content

[20] Id.

[21] Id.

[22] Greg Ip, Fed Weighs Its Options in Easing Crunch, WALL STREET J., Apr. 9, 2008, at A3, available at http://online.wsj.com/article/SB120768896446099091.html

[23] Id.

[24] Id.

[25] Id.

[26] Id.

Comments

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[Forex news]

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[Kimberly Mems]

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[Payday Loan Advocate]

The improper use of payday loans can lead to mortgage crisis that is why one of the biggest targets for politicians, as far as economics are concerned, is becoming the payday loan industry. Governors across the country are trying to rid their states of the industry altogether, and so far, Georgia, North Carolina, and Oregon have succeeded. The result was that bankruptcies, foreclosures, and also the number of overdraft fees due to bouncing checks went through the roof, which doesn’t do anything for the citizens afflicted in these turbulent times, and only is really good for the banking industry. Despite these negative effects, other states are looking to follow the example and do the same. Even at the national level, presidential candidate Barack Obama, is weighing in his own agenda on the issue, and advancing his own intentions on getting rid of the industry in the United States completely. If these measures, both on state levels and nationally, are successful, the results are going to be increased unemployment, more debt, more foreclosures, and an even worse economy.

[Josh Neumann]

Just another example of the government overstepping it's boundaires, rather than letting the market play itself out. This will come back to haunt them soon...