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Fed Moves to Provide Extra Liquidity Through TSLF

The Federal Reserve took action Sunday to provide additional liquidity for markets and expand the types of assets that broker-dealers can exchange for Treasury securities through its Term Securities Lending Facility - assets that now include municipal bonds.

However, market participants said the Fed's action to provide additional liquidity to the market in lieu of a federal governmental bailout of Lehman Brothers Holdings, Inc. may not have much of an effect on the municipal market, because firms are likely to hold onto their municipal securities and exchange their less liquid securities.

The Fed's move comes on the eve of its scheduled monetary policy meeting today, though economists indicate the Fed is likely to hold its target interest rate steady at two percent despite the turbulent market conditions.

In other action, Treasury Secretary Henry Paulson yesterday briefed President Bush on the government's role in the financial crisis that erupted over the weekend and, in a press conference from the White House afterward, tried to reassure Americans that the steps taken by the Fed, the Treasury, the Securities and Exchange Commission, and a group of ten firms will strengthen financial markets.

"We're working through a difficult period in our financial markets right now as we work off some of the past excesses," Paulson said. "But the American people can remain confident in the soundness and the resilience of our financial system."

Paulson said this latest market turmoil is evidence that the financial markets regulatory system needs to be overhauled and that the government also needs "major authorities" to be able to help "wind down institutions that aren't banks."

The Treasury secretary told reporters that the administration never considered providing funds for Lehman and that the circumstances between Lehman and the former Bear, Stearns & Co. are very different. "I do not take lightly putting the taxpayer on the line to support an institution," Paulson said. "Moral hazard is something I don't take lightly."

After a tumultuous weekend on Wall Street led by the Chapter 11 bankruptcy filing of Lehman Brothers Holdings, the Fed announced four steps to provide liquidity, which include steps to liberalize collateral required for Treasury securities and steps to provide greater access to Treasury funds.

The Fed will now accept a broadened array of assets at TSLF "Schedule 2" auctions, including all investment-grade securities, equities and municipal and corporate debt rated triple-B or higher. Previously, only Treasury securities, agency securities, and triple-A rated mortgage-backed and asset-backed securities could be pledged.

The TSLF was established by the Fed in March amid the Bear Stearns & Co. crisis to provide liquidity for the Fed's 20 primary dealers. The TSLF holdsauctions to allow the primary dealers to exchange realitvely illiquid securities for Treasury securities. The collateral requirements initially did not include municipal bonds or equities. This is in contrast to the Fed's Primary Dealer Credit Facility, which provides overnight loans to the primary dealers in exchange for collateral, and which has in the past expanded the eligible collateral to include muni bonds.

Additionally, the "Schedule 2" TSLF auctions will occur once a week instead of every two weeks and the total amount of liquidity offered at each of these auctions will be increased to $150 billion from $125 billion. The Fed also adopted an "interim final rule" that provides a temporary exemption to the limitations in section 23A of the Federal Reserve Act. The exemption allows all insured depository institutions to provide liquidity to their affiliates for assets typically funded in the tri-party repo market. The exemption will expire on Jan. 30, 2009 unless it is extended by the Fed.

Jim Glassman, senior economist at JPMorgan Chase & Co. said the Fed actions are "appropriate" and that the Fed understands unwinding Lehman "is going to require lots of liquidity in the market." The Fed is unlikely to cut interest rates because that would risk having "no more weapons left," he said.

"The real problem is liquidity, not interest rates," said David Wyss, senior economist with Standard & Poor's. "I think the only way they do a rate cut is in combination with Europe's central banks." There is a "fifty-fifty" chance of a 25 basis point rate cut, he said.

"At this point, we don't expect Lehman's problems to affect the FOMC's rate stance in general or its policy statement after this week's meeting," stated a research report released by Wrightson ICAP LLC Sunday, referring to the Federal Open Market Committee. "We presume that the FOMC's central forecast still looks for slow growth and uncomfortably high inflation in the short run, giving way to more moderate price increases and improving economic conditions next year," the report said.

However, the Fed fund futures market indicated yesterday that the Fed would lower the key interest rate by 25 basis points.

As for the Fed's expansions of collateral for its Term Securities Lending Facility, Evan Rourke, vice president and portfolio manager at MD Sass Investors Services Inc. in New York, said munis are less likely to be posted as collateral when assets like mortgage-backed securities are harder to trade.

"If I am anyone looking to maintain liquidity, munis, on a relative basis, have held their value better than other securities," Rourke said. "My guess is very little will get posted."

Firms looking for immediate liquidity, however, might be forced to exchange munis for the more liquid Treasury securities. The Treasury deal might help muni liquidity slightly if investors are looking to exit munis, he said.

Paulson commended the SEC and Fed for pulling together world financial leaders over the weekend to meet the current challenges and reduce market stresses, as well as the efforts of 10 banks to establish a $70 billion fund to reduce liquidity risks.

The 10 banks - Bank of America Corp., Barclays PLC, Citibank Global Markets Inc., Credit Suisse Group, Deutsche Bank AG, Goldman Sachs Group Inc., JP Morgan, Merrill Lynch & Co., Morgan Stanley, and UBS AG, each committed $7 billion each to the fund.

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