Central banks and pawnshops

May 4th, 2008

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Nowadays, if one is desperate for short-term cash, he can always tap his credit card for a cash advance at the local ATM and be charged exorbitant interest rates. In the past, in the days of our parents’ and grand-parents’ generation, cash desperate people would go to the pawnshops. To qualify for a loan at the pawnshop, one had to surrender his valuables as collaterals. It is only after one repaid the loan (plus interests) could one redeem his valuables.

This is what central banks do to banks. As this news article report, Fed expands auction, accepts wider collateral,

The Federal Reserve, along with other central banks, said Friday that it was increasing the funding it is providing to banks and announced that, for the first time, it was willing to accept bonds backed by auto loans and credit cards.

The Fed’s original statement can be found here,

In addition, the Federal Open Market Committee authorized an expansion of the collateral that can be pledged in the Federal Reserve’s Schedule 2 Term Securities Lending Facility (TSLF) auctions. Primary dealers may now pledge AAA/Aaa-rated asset-backed securities, in addition to already eligible residential- and commercial-mortgage-backed securities and agency collateralized mortgage obligations…

Using the pawnshop example, when a bank borrows money from the central bank, they do so via a repurchase agreement (or “repo”). In repos, banks have to surrender their assets (see Banking for dummies for more on what bank assets are) as collaterals to the central bank. After some time, the banks have to pay back the money plus interest in order to redeem their assets.

Traditionally, the Fed would only accept the highest quality assets, US Treasury bonds, as collaterals. But due to the credit crisis, the Fed (along with other nations’ central banks- see Reserve Bank of Australia entering the landlord business) is lowering the standards of collaterals to include top-rated residential and commercial mortgages. The Fed’s most recent statement indicates that they are lowering the standards even more (to auto loan and credit-card bonds). Using the pawnshop example, it’s like the pawnshop lowering the standard of the pawns that it will accept, say from gold jewellery to silver jewellery.

How much lower can it go?

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