Last week the Federal Reserve conducted a Term Security Lending Facility auction and there was a surprisingly high level of interest in the auction. Bids were high but the stop out level remained in line with recent auctions. I could not come up with a solid reason for the result but someone forwarded his analysis (by Credit Suisse I believe) and it is interesting so I provide it for your early Monday enjoyment.
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Last week’s TSLF for category 1 collateral illustrates the funding issues. The auction had a surprisingly high bid to cover (over 2) while earlier auctions had been undersubscribed. This reflects the GSEs relying on the dollar roll market to finance their mortgages (i.e., for forward settlement) that leaves the dealer long pass-throughs. The dealers now finance these through the TSLF.
Before the GSEs mainly financed their mortgages through their discount note programs. The recent turmoil surrounding the GSEs has led to dealers being more cautious with regards to underwriting discount notes and encourages the GSEs to rely on selling discount notes through their window, directly to real money investors. With a heavy volume of discount notes continually maturing, a liquidity risk nevertheless exists. The GSEs mitigate this via the dollar roll market. For the dealers their overall counterparty risk to the GSEs actually goes up (with exposure to the mortgage and to the GSEs on forward settlement). But against this the TSLF offers attractive financing with mortgage financing being offered at 2.4% versus a TSLF financing of around 2.10% for one month.
Originally published at Across the Curve and reproduced here with the author’s permission.