The private funding markets, where dealers typically finance their securities positions, were severely impaired in early 2008. Lenders of funds, worried about the value of collateral as well as counterparty credit risk, became increasingly concerned about losses on repurchase agreements. They responded by reducing the amount they were willing to lend for a given amount of collateral, halting lending against certain types of collateral altogether, and demanding greater compensation for accepting ­riskier collateral.

To address unprecedented liquidity challenges amid funding market stress, in March 2008 the Federal Reserve established a new auction facility. Through the Term Securities Lending Facility (TSLF), the Fed sought to promote liquidity in the funding markets as well as improve the operation of the broader financial markets, note Michael J. Fleming, Warren B. Hrung, and Frank M. Keane, in “The Term Securities Lending Facility: Origin, Design, and Effects” (Current Issues in Economics and Finance, vol. 15, no. 2, February 2009).

The authors explain that the TSLF increases the ability of primary dealers to finance their positions in the private markets. The facility allows dealers to bid a fee to borrow up to $200 billion in Treasury securities for a term of twenty-eight days by pledging as collateral other securities, including agency debt securities and mortgage-backed securities. They can then use the borrowed Treasuries, which are relatively easy to finance, as collateral to obtain cash in the private markets. As a result, dealers have less need to sell assets into illiquid markets, and lenders are less likely to experience a loss of confidence.

Fleming, Hrung, and Keane offer a detailed look at the TSLF. They discuss the market conditions leading up to the launch of the facility, the features that distinguish it from other Fed liquidity facilities, and the structure and operation of the program. They also review the first ten auctions, conducted in spring 2008, for early evidence of the facility’s use and effectiveness.

The study concludes that the TSLF contributes to improved liquidity conditions in collateralized funding markets by more effectively balancing supply and demand in the markets for Treasury and non-Treasury collateral. Just prior to the first auction, in late March 2008, the financing spread between overnight agency mortgage-backed-security repos and Treasury repos was 100 basis points. By April and May, it ranged between 0 and 20 basis points. Spreads in the less liquid term market exhibited similar patterns. These lower financing spreads, the authors suggest, provide evidence that the facility has been effective in improving market liquidity.