Fed Auctions Another $30B

Banks on Tuesday gobbled up said another $30 billion in short-term loans injected into the banking system by the Federal Reserve, the latest sign of the lack of liquidity for financial institutions.

Sixty-six banks bid $58.4 billion in the Fed's fifth 28-day auction through the term auction facility created in December. The interest rate was 3.01%, vs. 4.67% in December, a reflection of the Fed's aggressive cutting of its fed funds rate to 3% last month.

The Fed created the facility to allow it to lend directly to banks at a time when they are reluctant to lend to each other. Banks can borrow directly from the Fed through the central bank's discount window, but doing so carries a stigma of desperation that many banks try at all costs to avoid. The discount window carries a 3.5% interest rate.

The Fed has injected $130 billion in liquidity via the facility's semi-monthly auctions since December. And judging by recent Fed statistics, banks certainly need the capital.

Banks have a legal requirement to have a sufficient amount of money on hand to meet customers' needs. A lack of reserves would mean the bank would have to start turning down customers for loans, which could in turn cause a panic as depositors rush to pull their money out. The Fed does not note which banks are borrowing through the facility.

According to the Fed's FRB h.3 report, non-borrowed banking reserves, the capital cushion banks retain, less any money borrowed by the central bank, dipped to negative $8.7 billion at the end of last month.

While the number dropped below the required reserves back in 1990, there seems to be no precedent for the number to be negative. Professor Richard Sylla of New York University's Stern Business College could not remember a time that this had ever happened, "I do recall that the Fed raised reserve requirements in the '30s, but that's it."

Chris Whalen of Institutional Risk Analytics pointed out, "That if you look at the historic series, you haven't typically had a negative number. You have to ask, gee, why has this number changed?"

The Fed attempted attributed the drop to the money lent through the term auction facility. The report shows that non-borrowed bank reserves plummeted throughout January, starting the month at $8.7 billion and dipping to $202 million by mid-month. The Fed says the banks should have $40 billion on hand by the end of January.

Banks averaged between $40 billion and $43 billion in non-borrowed bank reserves during most of 2006. Then in December, it dropped to $37 billion, which is an eyebrow lifter, but no real cause for concern because the requirement was for $39 billion.

The central bank has pledged to continue to make the facility available until conditions improve. That hasn't made Wall Street feel any better about conditions in the credit markets.

"You put these numbers together and you have a system that is desperately short of liquidity," Whalen says.

Whalen pointed out that the term auction facility is intentionally open-ended. It essentially offers banks loans lower than interbank rates and they can put up whatever collateral they want.

"Ultimately, there is a lot of paper out there that we can't fund," he says. "Deals are getting redeemed instead of rolled over, so that money isn't coming in."

Another way banks can meet reserves is to raise cash fast. Some banks hit by mortgage-related losses, like Citigroup(C Quote), Washington Mutual(WM Quote) and Wachovia(WB Quote), have boosted capital reserves through the sale of preferred securities in recent months.