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The Motley Fool ^ | February 26, 2008 | Morgan Housel
Posted on Thu 28 Feb 2008 09:42:39 AM PST by AdamSelene235
Banking is one of our economy's most important players, financing the aspirations of everyone from homeowners to private-equity titans. Since last summer, the weakening collateralized debt market has mired the banking industry in one of the stickiest spots it's seen in decades. So when Fed chairman Ben Bernanke was faced with the possibility that panic in the banking industry might turn an ugly problem into an outright catastrophe, he sprung into action in ways we've never seen.
A bit of background Banks must keep specific amounts of cash on hand, called required reserves, to ensure that they can meet customers' withdrawal requirements. Money flows in and out every day at different levels, so when some banks fall behind, those with deeper pockets loan money out and cover the difference. Bank of America (NYSE: BAC) can lend to Washington Mutual (NYSE: WM), JPMorgan (NYSE: JPM) can cover Wachovia (NYSE: WB), and so on, until everyone is squared up at the end of the day. It's like the corporate version of a hippie commune.
But when money gets really tight, and lending between banks falls short, the Fed steps in and acts as a lender of last resort. It loans banks money through what it calls the discount window, albeit at a higher rate than banks charge each other. It really is last resort, because relying on the Fed for money is the equivalent of asking your parents for a loan; it doesn't exactly instill confidence in your financial well-being.
Uncle Ben to the rescue! When banks hit a logjam in December, Bernanke faced quite a bind. Interbank lending slowed as market uncertainly grew, yet banks were reluctant to use the discount window, for fear that the banking industry's health as a whole would be called into question. Their options were running low. Bernanke's solution: the term auction facility.
Term who? The term auction facility, or TAF, isn't too different than the standard discount window. It just allows the Fed to lend predetermined amounts of money, and let the banks bid on the interest rate. Most importantly, it doesn't come with the stigma of the discount window, which threatened further panic.
The Fed wasn't shy about how much money it was willing to front. A recent article in the Financial Times revealed that banks borrowed around $50 billion from the TAF as of mid-February. That's a lot of money, even for big banks. The latest round of loans, earlier this month, totaled $30 billion at 3%.