Transcripts of the monetary policymaking body of the Federal Reserve from 2002–2008.

Thank you, Mr. Chairman. As outlined in the memo circulated earlier to the Committee from Brian and myself, the staff is proposing two innovations to our suite of liquidity facilities. First, we are proposing to add a $50 billion options program to the TSLF. There is a precedent for this. We auctioned options in advance of Y2K. This proposal calls for selling options to primary dealers in a series of auctions beginning several weeks before each quarter-end. The options would be for the right to borrow Treasuries from the SOMA portfolio in exchange for schedule 2 collateral for a short period of time (a week or so) over the quarter-end period. If the option is exercised, the dealer would pay a fixed rate for the borrowing (we have currently penciled in this rate at 25 basis points, annualized—the same as the minimum bid rate on 28-day TSLF borrowing). The fine points of the program, such as the rate and the precise timing and tenor of the borrowing that the options would reference, would be determined after consultation with the primary dealer community. As you recall, in the rollout of the original TSLF program, we consulted with the dealer community after the program was announced. The dealer comments did result in changes in the program that we believe made it more effective, and the dealers certainly did appreciate the opportunity to have their views heard before the program was implemented. We anticipate that an options facility would be helpful in providing a means for dealers to purchase insurance that could be used to secure funding over stress periods such as quarter-end and year-end. Because the options would be auctioned well in advance of quarter-end, dealers should be able to better plan their funding needs over that period. The options program should help reassure dealers that they will be able to finance their less liquid collateral over these high- stress balance sheet periods. Greater comfort on the part of the dealers is likely to reduce the risk of a margin spiral in which forced liquidation of illiquid collateral leads to lower prices, higher volatility, and higher haircuts, which, in turn, provoke further liquidation. Debby Perelmuter will discuss the TSLF options proposal in greater detail in a few minutes.

Second, we are proposing to extend the maturity of Term Auction Facility loans to 84 days from 28 days. The size of the total program would remain unchanged at $150 billion. The auction cycle would remain biweekly, with the size of each auction cut proportionately to the rise in maturity—to $25 billion per auction in six biweekly cycles covering 12 weeks from the current program of $75 billion in two biweekly cycles covering four weeks. We also are proposing to change our overcollateralization rules. In the current program, we require that TAF bids must not exceed 50 percent of pledged collateral. But the overcollateralization can be withdrawn after the loans are made. Under the new rules, we would change this standard so that the sum of all outstanding term TAF and term PCF loans could not exceed 75 percent of available collateral, both initially and throughout the term of the loans. As the Chairman noted, the ECB and the SNB have indicated that they will modify their programs accordingly. The ECB is seeking to raise its swap line authority to $60 billion from $50 billion. They are seeking to do this because the current swap line of $50 billion is not easily divisible into a six biweekly auction cycle. We anticipate that they will decide to raise their biweekly auction size to either $9 billion or $10 billion—so the total swap draw is likely to rise to either $54 billion or $60 billion. The motivation for the maturity extension is provide greater support to term funding markets. For some time, banks have asked for longer-term maturity TAF loans. This is attractive to them for two reasons: (1) almost all of these loans will extend over quarter-ends—periods in which balance sheet stress is likely to be greatest—and (2) the longer maturity would also help banks extend the average maturity of their borrowings. This change will also put the maturity of TAF loans more on par with the ninety-day limit of the primary credit facility. Sandy Krieger will discuss our TAF maturity extension proposal in more detail shortly.

So what will these two programs do? My own view is that these new proposals are evolutionary rather than revolutionary. They are unlikely to result in a dramatic improvement in term funding conditions. However, they are likely to be helpful at the margin. In particular, I think they will help reduce the risk of the type of margin spiral that could potentially turn a period of balance sheet stress into something systemic. In my view, this is a worthwhile goal. Better to take steps now to reduce the risks of bad outcomes than wait to respond only after the bad outcomes occur. Introduction of these program innovations also will demonstrate that the Federal Reserve is actively on the case, refining its liquidity suite in order to make its tools more effective.

Will introduction of these changes be alarming to the market? I don’t think so. Because they would be announced simultaneously with the extension of the PDCF and the TSLF programs, the changes are likely to be perceived as an ongoing refinement of the existing programs rolled out as a package with the PDCF and TSLF extension rather than as a program that signals great concern about problems known to the Federal Reserve but not to market participants.

Should we worry that the $50 billion TSLF options program further commits the Fed’s balance sheet, making it more difficult to respond to large, unanticipated PCF or PDCF borrowing? Although this is a legitimate issue, it should be emphasized that the Federal Reserve has other means of easing its balance sheet constraints, which the staff has been actively pursuing. Also, the regular TSLF program has been undersubscribed—currently only $113.5 billion of TSLF loans are outstanding. This will climb to $123.1 billion tomorrow, when today’s auction settles. This means that there is a bit more headroom than suggested by the $175 billion size of the TSLF auction program and the $200 billion that was authorized. Moreover, in the worst- case scenario of massive PCF or PDCF borrowing, I wonder whether the $50 billion claim on the Fed’s balance sheet represented by the options would indeed be significant at the margin. Debby Perelmuter will now explain how we anticipate that such a TSLF options program would work.

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