Fitch Ratings is encouraged by yesterday's announcement by the Federal Reserve (Fed) as Fitch believes it has potential positive implications for U.S. financial institutions. Liquidity in the financial markets has been constrained in recent months with particular pressure in the last several days. Uncertainty has dominated sentiment with spreads on certain instruments widening substantially beyond normal conditions.

Large U.S. banks and broker/dealers maintain a substantial portfolio of securities for financial flexibility and typically provide interim financing to all types of investors. Counterparty unwillingness and liquidity preservation have undermined the fluidity in the U.S. markets for highly liquid collateral. Fitch believes the broadening of acceptable collateral by the Fed, particularly for mortgage-backed securities, should relieve some of the recent market pressures. Improvement in liquidity is expected in the near term although Fitch realizes that sales and financings may not be immediate with limited appetite for balance sheet growth in advance of the end of the first quarter.

Recent ratings actions have been taken related to an expectation of increasing credit losses for largely consumer related assets. Liquidity in the largest U.S. financial institutions has remained strong although Fitch acknowledges that there has been little ability to reduce unwanted exposures. Fitch is hopeful this action by the Fed will improve liquidity such that transactions will return to higher levels and risk may be reduced - albeit with appropriate losses recognized. Earnings are expected to be challenging due to market value changes particularly related to mortgage portfolios and leveraged loans. The financial institutions that borrow under the Term Securities Lending Facility (TSLF) will still be subject to the established haircuts on their collateral and potential margin calls if the collateral deteriorates in value.

The Fed announced a significant expansion of its securities lending program, in conjunction with additional moves by the Bank of Canada, the Bank of England, the European Central Bank (ECB) and the Swiss National Bank. The Fed's new TSLF, which will hold its first auction on March 27, has several features that should ease market liquidity conditions.

* The facility will be available to primary dealers, which encompasses a number of investment banks as well as commercial banks;
* TSLF agreements will have a 28 day term (instead of overnight);
* Qualifying collateral is expanded to include additional types of bond securities such as certain private label MBS;
* The Fed will lend Treasury bonds against the dealers' bond collateral, leaving reserves in the banking system level.

The Fed has committed a total of up to $200 billion to the TSLF program. These moves follow the FRB's announcements last week announcing an increase in the Term Auction Facility (TAF), which is only available to depository institutions, to $100 billion, and an increase in term repurchase transactions with primary dealers to $100 billion, under which the Fed will lend cash against the traditional eligible bond collateral.

By doing this, the Fed scaled up the absolute amount of term liquidity injection compared to the previous term auction facility and effectively broadened their definition of eligible collateral in repo transactions. They are offering their own holdings of U.S. Treasuries' to be swapped for asset-backed securities (ABS).

As the Bank for International Settlements noted in a recent report, the Fed (previously) had the widest range of collateral of any of the major central banks in its overnight standing facility but the narrowest range for its longer term repo transactions (i.e. just U.S. government or agency bonds). The announced changes should see the Fed engaging in transactions more akin to what the ECB is doing in Europe in providing a backstop for ABS.

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