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Monday, March 17, 2008

The Federal Reserve Term Auction Facility

The Federal Reserve recently created the "Term Auction Facility" (TAF) to bail out struggling banks. I found a decent description in this article on lewrockwell.com, cited on BradSpangler.com.

Normally, when the Federal Reserve "monetizes the debt", it purchases Treasury Notes with newly printed money.

Borrowing at the Fed Funds Rate or Discount Rate is normally only available to commercial banks (banks that accept customer deposits). Many investment banks, such as Bear Stearns, don't accept customer deposits. When they borrow from the Federal Reserve, they borrow through an intermediary clearing firm. For example, Bear Stearns borrows from Morgan Chase.

According to some sources I read, the TAF allows investment banks to borrow from the Federal Reserve directly, instead of borrowing through a commercial bank. Bear Stearns needed to borrow via Morgan Chase because the TAF isn't effective for a few more days. With the repeal of many banking regulations, the distinction between investment banks and commercial banks is blurred. The problem with the financial system is *NOT* too much or too little banking regulation. The problem is the Federal Reserve itself, which provides the financial industry with a massive government subsidy, paid by everyone else as inflation.

In the TAF, the Federal Reserve is lending the banks Treasury Notes in its inventory. The bank sells the Federal Reserve junk bonds in its inventory, probably subprime mortgage bonds.

These are structured as "repurchase agreements". The term of the repurchase agreement is around 1 month. The arrangements were "competitively bid". However, the interest rate is approximately the same as the 1 month Treasury Note rate. If not, there would be an arbitrage opportunity.

How does this help banks? Treasury Notes are AAA rated. Banks may use leverage ratios around 100x when investing in Treasury Notes. Many subprime mortgage bonds have a junk rating now. With junk debt, banks are limited to around 5x-10x leverage ratios. Large banks could be faced with margin calls, forced to sell this debt at a steep discount.

The TAF gets these junk assets off the banks' balance sheets. The Federal Reserve is the creditor. Of course, the Federal Reserve is assuming no risk. It can always print new money and give it to the banks!

With a "1 month reprieve", banks can let inflation take its course. In one month, there will be 2%-3% inflation. The houses backing those subprime mortgages will increase in value. Eventually, there will be enough inflation that those houses can be sold to pay off the mortgages.

Notice that small banks like Countrywide and Thornburg were allowed to fail. Large banks get a bailout. The TAF is *ONLY* available to large banks, the ones that are "too big to fail". The Federal Reserve has *NO CHOICE* but to bail out large banks. Otherwise, the financial system would unravel as large banks are forced into bankruptcy. A bank with a market capitalization of only $1B is considered "small".

As usual, the Federal Reserve is bailing out large banks. Under the rules of a corrupt monetary system, the Federal Reserve has *NO CHOICE*. The Federal Reserve *MUST* bail out large banks or the entire financial system will unravel. This bailout isn't free. It's paid by everyone else as inflation.

Under the rules of a corrupt monetary system and taxation system, you have *NO CHOICE* but to finance this bailout. The only way out is to switch to sound money and to avoid paying income taxes.

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