Buzz Cut

Give the Fed credit: today, the central bank announced a new and innovative mechanism of getting more "liquidity" into the banking system, what they're calling a term auction facility. Basically, you can think of this as a new and improved discount window -- another way for the Fed to fulfill its function as "lender of last resort."

This kind of facility can come in handy when fundamentally sound banks experience a liquidity crisis: think of Jimmy Stewart's old Building and Loan in It's a Wonderful Life. Banks, many of which can't liquidate their assets quickly enough because the markets for those assets have dried up, will now be able to use them as collateral for borrowing from the Fed. This will allow them to go about their business as usual, and pay off any nervous depositors. In theory, the discount window already serves this purpose -- but banks have historically been shy about discount window borrowing on the grounds that this sends a bad signal about their underlying strength.

Good idea -- but two questions that come to mind are: (1) What exactly are these assets that are going to be pledged as collateral? Are these going to be exactly the same opaque, impossible-to-value CDOs that landed banks in trouble to begin with? If so, what "haircut" will the Fed take (i.e., how much of the asset's supposed value will the Fed lend against)? The advice from the standard central bank playbook on this matter, Bagehot's Lombard Street, is to lend only against good collateral, and only in situations where liquidity -- not solvency -- is the issue. And (2) why would banks prefer to use the term auction facility instead of the more conventional discount window?

In the end, one has to wonder whether the Fed's liquidity enhancing actions can, innovative as they are, really solve the underlying problem: billions and billions of dollars of nonperforming assets. Clearly, there are some serious credit problems out there, and all the liquidity in the world won't solve them. Just ask the Bank of Japan: in its efforts to counter the effects of the collapse of its banking system in the 1990s, the BoJ progressively expanded the range of assets it would accept as collateral for its lending operations. These measures did little to solve the banking problem, of course; that only came with the workout or liquidation of the nonperforming loans. There's no reason to think the U.S. would be any different.