The current credit crunch began in earnest during the summer of 2007 and the Fed’s first response was to lower its discount rate. The Fed brought to the forefront a tool that has not gotten much attention in almost two decades.  But the Fed – despite criticism on being too loose by some inflation hawks – has recognized that there is a difference between a liquidity crisis versus economic weakness and the increased use of the discount window as a policy tool shows that recognition.  And the Fed has created a number of new lending facilities to increase access to the Fed’s discount window and to improve the functioning of the credit markets. But just what is the discount window and where does the new alphabet soup of new lending facilities fit in how the Fed has been creatively addressing the credit crunch?

Background on the discount window

What is the discount window? There actually is not just one discount window – each of the regional Fed district banks has their own. The discount window is the regional banks’ lending facility for depository institutions. Institutions generally go to the discount window when they cannot get reserves in the open market to meet reserve deadlines. Lending traditionally is for overnight loans but the Fed last year extended the loan period.

Prior to the current credit crunch the Fed frowned on institutions that came to the discount window too often. This is not as much as issue since January 2003 when the Fed changed the discount rate from being below the fed funds target rate to being above the fed funds target rate. The discount rate is the rate the Fed banks charge borrowers for funds obtained at the discount window. The discount window obtained its name from the fact that early in its history, the Fed banks would take the borrowers’ securities and then discount them for the value the Fed would allow as collateral.

Changes in the discount rate can only be initiated by a regional Fed bank’s board of directors but any change must be approved by a majority vote of the Federal Reserve Board of Governors. The discount rate is not voted upon by the FOMC (Federal Open Market Committee) which decides the fed funds target rate. Because regional Fed banks’ boards of directors meet at different times each month, a request to change the discount rate is generally by only a few of the regional banks at a time and even by as few as one regional bank. The presidents of the district Fed banks do not actually vote on the discount rate but typically make recommendations to the regional bank directors when they review the discount rate as mandated at least every two weeks. When the Board of Governors approves a rate change for the requesting bank or banks, the remaining banks’ board of directors hold unscheduled telephone votes to submit requests to match the approved discount rate changes – usually within one business day.

Why has the discount rate not been important to Fed watchers in recent years? Starting in 1989, the Fed began to announce its fed funds rate target. Prior to that, Fed watchers had to infer the fed funds target from movement in the fed funds rate in the open market and by tracking money supply. When the Fed wanted to “announce” that policy had settled in at a new level, the Fed would change the discount rate to indicate that the fed funds rate had been locked in as a change in policy. As seen in the first chart, the effective fed funds rate was far more volatile prior to 1989. This pre-1989 period is when changing the discount rate was known as “ringing the gong” – the Fed making sure the markets understood that policy had changed.

The discount rates’ comeback

The Fed’s first move to alleviate the current credit crunch was when it cut the discount rate by 50 basis points on August 17, 2007 to 5.75 per cent, thereby reducing the gap between the discount rate and federal funds target to 50 basis points from the traditional 100 basis differential. The intent was to encourage financial institutions to go to the discount window to help meet liquidity shortfalls. The rate cut was made at the request of the New York and San Francisco Fed banks – although another regional Fed had requested a smaller rate cut earlier.

The August 2007 cut in the discount rate did not have enough of the intended effect as banks feared that if it became know that they had gone to the discount window that those banks would be seen by rivals as in shaky financial condition. The impact of lowering the discount rate differential on liquidity was also limited by the fact that only depository institutions (such as commercial banks and others) in sound financial condition could borrow at the discount window. The Fed needed additional methods to improve liquidity and eventually decided to expand the lending of reserves.

On a final note regarding the discount rate, the Fed re-emphasized that it wanted depository institutions to use the discount window if needed for liquidity needs. The Fed made its point with another surprise cut in the discount rate on March 16, 2008 to 3.25 percent, narrowing the gap with the fed funds target to a mere 25 basis points.

The Term Auction Facility

Following the surprise cut in the discount rate in August 2007, the Fed cut both the fed funds target rate and discount rate September 18, October 31, and on December 11. But the Fed decided that other measures, not tied to interest rate cuts, were needed to improve liquidity, measures that would not have the stigma of a bank going to the discount window. On December 12, 2007, the Fed announced multiple actions to address “elevated pressures in short-term funding markets.” For the Fed, the key action was the establishment of a temporary Term Auction Facility or TAF. Essentially, the Fed would conduct an auction of a pre-announced amount of reserves. As with the discount window, only depository institutions in generally sound condition would be allowed to participate. But the Fed did expand the types of collateral that it would accept for the auction compared to that for open market operations, thereby loosening up the credit markets somewhat. The first TAF auction was held December 17, 2007 for $20 billion. The Fed has since raised the auction amount to $50 billion – injecting more liquidity into the markets.

The Term Securities Lending Facility

The Fed announced on March 11 that it was creating another lending facility to improve liquidity – the Term Securities Lending Facility (TSLF). Through auctions, the Fed planned to lend up to $200 billion of Treasury securities to U.S. primary dealers for a 28 day term instead of overnight. Primary dealers are the twenty banks and securities broker-dealers that deal directly with the New York Fed when it engages in open market operations to implement monetary policy. The primary dealers agree to make bids and offers on the Fed’s open market transactions and then resell Treasury securities to the public. The TSLF importantly would be accepting new types of collateral, including federal agency debt, federal agency residential-mortgage-backed securities (MBS), and non-agency AAA/Aaa-rated private-label residential MBS.

The institution of the TSLF was the first time that primary dealers were able to participate in an expanded auction program. Under TAF, only banking institutions could participate. Auctions are held on a weekly basis, with the first having been on March 27, 2008. With the TSLF program, acceptance by the Fed of certain high quality mortgage-backed securities and federal agency debt as collateral was a big deal. This helped liquefy the mortgage market notably.

The Primary Dealer Credit Facility

The most recent Fed creation to improve the functioning of the credit markets was the Primary Dealer Credit Facility (PDCF), announced on March 16 and opened for business on March 17. The Fed originally announced that the PDCF would last six months but could be extended further. The PDCF is an overnight loan facility designed to improve the ability of primary dealers to provide cash to participants in securitization markets during temporary cash shortfalls.  The PDCF is not auction based and essentially is like opening the discount window to primary dealers. The lending rate is equal to the discount rate at the New York Fed.

Loans are for one day but new loans can be taken out each day for up to 120 business days although the PDCF is subject to a frequency-of-usage fee. An important feature of the PDCF is that it takes an expanded list of collateral – collateral that is eligible for open market operations, as well as all investment-grade corporate securities, municipal securities, mortgage-backed securities, and asset-backed securities for which a price is available. Only market priced collateral is eligible for the PDCF. This expanded list of collateral helped to improve liquidity. Notably, primary dealer JP Morgan was approved to use the PDCF to buy out distressed investment house Bear Stearns.

How do they differ?

Discount Window

The discount window traditionally is for limited use on a rare basis by depository institutions (for example, commercial banks) and typically for just overnight loans. The Fed, however, expanded terms to up to 30 days with its August 2007 rate cut. Only depository institutions in sound financial condition can go to the primary discount window. The lending rate is fixed according to the established discount rate. The discount window is open on an ongoing daily basis.

The Term Auction Facility (TAF)

The TAF is limited to depository institutions in sound financial condition. The lending rate is not fixed and is determined by a market auction but a minimum bid rate is determined by a measure of the expected overnight fed funds rate. The TAF auctions currently are being held every two weeks. The term of the loan generally is 28 days and the collateral is the same as required at the discount window.

The Term Securities Lending Facility

The TSLF is an auction for primary dealers and not depository institutions. The accepted collateral is a much wider range than either for the discount window or for open market operations and includes federal agency debt, federal agency residential-mortgage-backed securities (MBS), and non-agency AAA/Aaa-rated private-label residential MBS.  Minimum bids are set.

The Primary Dealer Credit Facility

The PDCF is open only to primary dealers and is not auction based. Primary dealers essentially have access to the discount window but with a wider range of collateral accepted - collateral that is eligible for open market operations, as well as all investment-grade corporate securities, municipal securities, mortgage-backed securities, and asset-backed securities for which a price is available. The lending rate is the discount rate at the New York Fed.

The bottom line

Since the credit crisis surfaced in mid-2007, the Fed has not just relied on lower interest rates to improve liquidity but has created three new lending facilities to more directly inject liquidity into the financial markets. Both depository institutions and primary dealers now have greater access to funds from the Fed during the healing of the financial markets from sub-prime and related problems. Although the jury is still out, the economy certainly would be far weaker without these new facilities.