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Sunday, September 28, 2008

No Response to a 25% Increase in Fed Liquidity

Ahead of an official bailout, from September 10th through September 24th, the Fed pumped ~$250 Billion of liquidity into the banking system through the Federal Reserve Bank "FRB" credit (the "FRB" credit is how much money the Fed has loaned to the banking system). The FRB credit spiked from $888 Billion to $1,135 Billion. This was an unprecented increase of more than 25% from levels in August and a month over month increase 5x larger than seen after 9/11.

Breaking this down further, we can see the majority of this increase has fallen into "Other Loans".

What are these other loans? According to the Federal Reserve, credit extension to AIG (September 18th), non-recourse loans to U.S. depository institutions and bank holding companies to finance their purchases of high-quality asset-backed commercial paper from money market mutual funds (September 19th), and credit extension to the U.S. and London based broker-dealer subsidiaries of Goldman Sachs, Morgan Stanley, and Merrill Lynch against all types of collateral that may be pledged at the Federal Reserve's primary credit facility for depository institutions or at the existing Primary Dealer Credit Facility (September 21st).

Unfortunately, credit markets didn't respond, thus the need for additional Treasury balance sheet the bailout will provide. Per the WSJ:
“We have a complete disconnect between monetary policy, low interest rates, and low federal-funds rates and credit and banking conditions,” says Adolfo Laurenti, senior economist at Mesirow Financial in Chicago. “Even if fed rates are at 2% and they’re doing whatever possible to inject liquidity into the system, the transmission mechanism is clogged and you don’t see growth.”

That’s why the Fed has responded lately by going nuts. Helped by money it is borrowing from the U.S. Treasury, in the seven-day period ending Sept. 24, the Fed increased its own credit at its reserve banks by 18% to $1.134 trillion.

The Fed is using its funds to buy asset-backed commercial paper and others types of assets from the nation’s banks, who have remained frozen while money-market funds lose their value and investors retreat to the safety of Treasury notes.