With credit markets extremely tight due to the continuing unavailability of short term commercial paper (CP), The Federal Reserve, The Bank of Japan, The Bank of England, The European Central Bank, The Bank of Canada and The Swiss National Bank have decided to experiment with the monetary system.Let me say straight away, the risk involved in this new venture is high, not only to the whole credit based monetary system but to the Central Banks themselves. That said, if it succeeds then the pressures in the credit markets should be lifted, allowing conditions to become conducive to further lending. The stakes are very high indeed.

So what exactly is the TAF designed to do? There appear to be 2 functions.

The first is to allow dollar swaps from the Federal Reserve to the other Central Banks to help alleviate dollar based liquidity problems outside the US.

The second function is more complicated, co-ordinated and risker.

As the CP market froze and then contracted, due to the lack of confidence Banks had in each other and other Institutions to repay (or service) the short term debt, the Central Banks offered funds through discount windows of one form or another, usually at rates higher than base but lower than commercial rates. After the Northern Rock debacle, borrowing from such avenues was not thought to be a wise move.

Time however, is against those who had borrowed using CP. As maturity dates approach it has become apparent that the CP market has not recovered to its pre-summer liquidity, indeed the CP market appears to be closed to new issuance. The short term loans used to purchase longer term assets or to fuel carry trades (selling low yield currency to buy high yield other denominated assets) will have to be repaid. This has now come to a climax as year end rolling of positions has been placed under threat or become non-viable.This was not part of the original plan when the lending had been entered into. Indeed, like Northern Rock the plan was to keep rolling the short term debt into new short term loans allowing the long term positions to continue.
With the facility withdrawn the plan became unstuck and the repayment of the loans would require sale of the assets bought. If the assets had appreciated then the position could be unwound without a capital loss. On the other hand if the asset had dropped in price then the amount owed would have to be made up using the Bank or Institution own reserves. As most of the borrowing had been used to bolster leverage (margin) then losses would be amplified, threatening their solvency. This also amplified the lack of lending, as Banks etc hoarded their reserves.

Back in September The Federal Reserve drew up the TAF as an answer to a US-centric problem. The idea was not implemented as it appeared credit markets were stabilizing. However that stabilization was fleeting and as conditions worsened the TAF plan was dusted off and put forward to other Central Banks as a solution.

That solution is to replace the traditional CP market, allowing the Central Banks to replace the previous participants. This is a full test of the Lender of Last Resort Theory where Governments or their Agencies are allowed to interfere in a capitalist structure.

At first glance the plan seems workable. There are however weaknesses which could become exposed, leading to further problems.

Firstly, the action must be co-ordinated between all participants, including the Bank of Japan, who appear not to be part of the TAF but are required to allow currency markets to flow freely. As much of the carry trade is funded by the Yen they are an integral part of the system. This could lead to political pressures building if the Yen is strengthened, hurting the Japanese export dominated economy.

Secondly, previous attempted international multi-agency intervention has not done well in financial markets. The attempts to keep Wiemar Germany afloat and the ERM regulated spring to mind as these efforts resulted in conditions that either worsened the problem or allowed speculation to destroy a framework. The risk to TAF would be the latter, where speculation in forex markets could endanger stability. More likely though is a stress test of the carry trade. It appears that the forex markets have already identified which assets are at risk, albeit not intentionally. When the TAF announcement was made gains in emerging market currencies and carry trade favourites, such as the NZD, AUD, TRY, BRL MEX and GBP were seen in expectation of continued risk taking in carry trades.

If the Central Bank intervention is to allow either an orderly unwinding of Emerging Market carry trades or a continuation of general carry trade conditions then speculative attack on TAF is a real possibility, not unlike Soros Vs Sterling. Shorting Emerging Markets, thus pressuring assets lower would force those in the carry trade to liquidate (costing capital reserves) or to approach TAF for higher borrowing, pressuring forex levels. Systemic risk would increase, either through a viscous circle of liquidations forcing prices of assets lower (along with other sellers heading for the exits) or a destabilization of forex levels requiring Central Bank intervention in interest rate markets.

On the plus side TAF has some flexibility, when initial lending operations were announced it was made clear that others could follow as required. TAF does not seem to have a lifespan either, possibly removing the bottleneck of the year end / Jan 08 roll over requirements. Of greater importance are the amounts of funding available, which should be enormous and the lack of a penalty rate on the interest charged. This should make TAF a much more attractive alternative than the higher interest rate required at discount window facilities..

Although the risks to TAF are high, the risks to the reputation of Central Banks are even higher. If this experiment fails then confidence in the system as a whole would collapse. Central Banks themselves are in danger of becoming victims, whose role and function could be radically altered or even removed in the event of failure.

An experiment of this nature has never been seen before and its unclear as to what the outcome will be. What is known is that stock markets hate uncertainty and that may well drive market direction into 2008 and beyond.

Market Snippets

Gold rallied to well over $812 on news of TAF implementation. The stock markets in Europe generally rallied on the news, with the FTSE closing near the high of the day. The Dow however seem more cautious, giving up the gains made on the TAF announcement.

Commentary by Mick Phoenix

on behalf of An occasional letter from The Collection Agency

Please Note: This article is to inform your thinking, not lead it. Only you can decide the best place for your money, and any decision you make will put your money at risk. Information or data included here may have already been overtaken by events – and must be verified elsewhere – should you choose to act on it. The views in the article are for informational purpose only.