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What happens if the value of a Participant’s available collateral drops below the amount it has won in the Auction before Settlement Date?
The value of each winning Participant’s available collateral must be large enough to cover the TAF Advance when the advance is booked on the Settlement Date. If the margined value of a winning Participant’s available collateral were to fall below the amount of TAF Advance awarded to it in the Auction at any time before, on, or after, Settlement Date and before Maturity Date, the Participant would need to pledge additional collateral to cover the shortfall or the Reserve Bank may exercise its remedial rights under OC-10.
...I am not certain how much of this is due to real stress as opposed to banks taking advantage of a free lunch, since the TAF is giving out one-month loans at 3.123%. at the Jan. 29 auction. That's less than interbank rates, and you get to post terrible collateral too. Everyone with an operating brain cell should be taking as much of this dough as they can, and they clearly are.
But having now created dependence on unduly cheap money, and getting an unprecedented and (at least to me, Shedlock, and concerned readers) scary chart, how is the Fed going to wean the banks off the TAF? And if we have another credit seize up despite the TAF, one can only expect the Fed will crank up the level of funding on offer...
In the second mode, asset prices fall because investors recognize that they should never have been as high as they were... This kind of crisis cannot be solved simply by ensuring that solvent borrowers can borrow, because the problem is that banks aren't solvent at prevailing interest rates. Banks are highly leveraged institutions with relatively small capital bases, so even a relatively small decline in the prices of assets that they or their borrowers hold can leave them unable to pay off depositors, no matter how long the liquidation process.
The problem is not illiquidity but insolvency at prevailing interest rates. But if the central bank reduces interest rates -- and credibly commits to keeping them low in the future -- asset prices will rise. Thus, low interest rates can make the problem go away... the Fed has shifted over the past two months toward policies aimed at a second-mode crisis -- more significant monetary loosening, despite the risks of higher inflation, extra moral hazard and unjust redistribution.
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