Financial markets on Wednesday will pore over the results of an unprecedented $20 billion cash auction conducted by the Federal Reserve in a search for signs it is helping soothe troubled credit markets.
The Fed auctioned off the money on Monday as part of a coordinated move by central banks around the globe to thaw frozen credit markets. It will release the auction results at 10 a.m. EST on Wednesday.
Demand for the funds and how much banks are willing to pay for them will signal how deep financial distress is and how important a role the Fed and other central banks can play in easing strains.
If there was no demand for this liquidity, obviously the institution didn't work the way it should have been working, said Torsten Slok, an economist with Deutsche Bank. And if there was excess demand, of course it was very successful. That is what we will try to learn.
A key barometer of the success or failure of the auction will be how the benchmark three-month London Interbank Offered Rate, or Libor, reacts. As a rising tide of U.S. mortgage delinquencies sparked a global credit crisis this summer, interbank borrowing costs jumped to unusually high levels when compared with the Fed's target for overnight lending.
LIBOR THE KEY
Money market rates fell on Tuesday.
The best gauge is Libor, said Jan Hatzius, an economist for Goldman Sachs in New York. It's already come down substantially, and should come down further if the (Term Auction Facility) is successful.
The Fed and other major central banks, including the European Central Bank, announced an unusual coordinated action last week to make short-term cash available to banks that were having trouble raising money for their operations.
As part of the joint action, the ECB also auctioned off $20 billion on Monday, while the Swiss National Bank pumped $4 billion into the markets.
On Tuesday, the Bank of England offered 10 billion pounds ($20.1 billion) in an auction as part of the coordinated plan, while the ECB delivered 348.6 euros ($500 billion) in two-week funds as part of a weekly refinancing operation.
Demand for funds offered by the BoE was muted, suggesting a less urgent need for funding than originally feared. But demand for the ECB offering was strong.
(Banks) are really in desperate need of liquidity, said Harm Bandholz, an economist for UniCredit in New York. I wouldn't be surprised if we see a lot of bids at the higher end in the Fed's auction, he said.
Mortgage failures were the legacy of a five-year U.S. housing boom, where after many years of rising house prices, lenders relaxed standards and borrowers were able to get loans that were at the limit of their ability to repay. When house prices flattened or fell, and variable interest rates reset at sharply higher levels, many such borrowers defaulted.
Rattled by surprise revelations of losses from investments backed by U.S. mortgages, banks began to hoard cash to cover possible losses.
ERASING THE STIGMA
To deal with the credit crunch that burst into view in August, the Fed first lowered the discount rate it charges banks for loans, then cut the benchmark federal funds rate, which governs interbank lending, in several increments to its current level of 4.25 percent
Credit markets improved for a time, but seized up again in early December as financial institutions prepared to close their books for year-end and some reported large-scale losses on assets tied to failed mortgages.
The coordinated central bank action involves two Fed auctions this week of up to a total of $40 billion, to provide funds for about a month's maturity. The Fed is expected to announce some details about the second auction on Wednesday.
In coordination with those two auctions, the Fed opened $24 billion in foreign exchange swap lines with the ECB and the Swiss National Bank.
Two more Fed auctions are scheduled for January, with amounts to be determined, and additional auctions are possible.
The Fed hopes the auction facility, which provides anonymity to borrowing banks, will erase the stigma attached to borrowing from the central bank's discount window, which has been associated with banks desperate for funds.
(Editing by Diane Craft)