On November 28, 2007 the Federal Reserve started a massive year end injection of liquidity into the financial system. On December 11th, the Fed once again lowered the funds rate a quarter of a point (for a total of 100 basis point drop since the half point cut on September 18th). While neither of these events were extraordinary, what happened the next day was.
On December 12th, the Fed announced the creation of its Term Auction Facility . The TAF program was open to any bank or depository institution, which would be allowed to bid for one-month loans up to the total amount of funds being auctioned off. The winners had a wide-choice of what they could pledge as collateral, including mortgage-backed securities that could not be traded and had no market price. In exchange for their possibly worthless securities, banks and brokers could get cash from the Fed. This new program represented a sea change in Fed operations.
First, the Fed would be offering up sums of money in auctions to banks and depository institutions instead of having them come to the Fed to get a loan. Using the Fed's discount window was usually only done by institutions teetering on insolvency and was carefully avoided by any institution that wanted to preserve its reputation. The Fed finally found a way around this impediment to getting money to struggling banks by offering the money at auction, guaranteeing an injection of liquidity into the system at the amount auctioned off and removing the stigma for those who got the money.
The second major change the TAF introduced was that the Fed was willing to take even worthless paper as collateral for a loan. During its history the Fed usually only accepted treasuries as collateral. With the TAF, it effectively began engaging in subprime lending itself . By doing so, it was bailing out the banks that had foolishly engaged in this practice - and who might have become insolvent if they couldn't get rid of their subprime paper.
When the TAF was announced in December, the original auctions were for $20 billion each. By January 2008, this amount was raised to $30 billion. By March each auction was for $50 billion and two additional Fed lending facilities would be introduced (the TSAF and the PDCF) - breaking even newer ground for Fed operations.
Next: Economic Predictions for 2008
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