The short-term credit market, once thought to be of
little capital risk to investors, has seized up
staggered by the deleterious impact of illiquidity.
Grave doubts regarding the stability of the underlying
collateral notably the value of pooled mortgage
securities have led to a rash of defaults and
restructuring. This panic has now metastasized,
spreading to other markets once esteemed as bastions of
conservative investment allocation (such as the Auction
Rate Muni market) markets now desiccated by the
evaporation of bid activity.
Over the past several months the Federal
Reserve has acted aggressively to mitigate this threat
to our financial system, lowering the Federal Funds rate
from 3.0% to 2.25% (with the discount rate now at 2.5%).
In addition, to create liquidity in unattractive
security classes the Federal Reserve instituted the Term
Auction Facility (TAF). The TAF allowed member
banks to offer Mortgage-Backed Securities (valued at
par) as collateral for overnight repurchase agreements
with the Fed. In March the Central Bank expanded this
policy with the establishment of the Term Securities
Lending Facility (TSLF) which permits the delivery of a
variety of assets (including MBS) for a 28 day term. The
first auctions in March and early April amounted to $100
billion with the Fed committed to auctioning off another
$100 billion in the next two months. The degree to which
this has cleared the log-jam in the money markets will
be debated by academics on an ex-post basis. However, as
investors we remain concerned that the current high
degree of leverage combined with deflating asset prices
may result in central bank policy becoming impotent.
Martin Feldstein, President of the National Bureau of
Economic Research, has suggested that interest rate
policy will be less effective during this economic
contraction. The reason: asset impairments and recent
decreases in real asset prices provide little incentive
for financial intermediaries to lend out capital. Even
when capital is furnished, institutions are continuing
to demand higher rates to compensate for capital risk.
As a consequence, measures of credit risk, such as the
TED spread, remain at elevated levels....
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