Yesterday we wrote about why we were alarmed with the results of the TAF auction.   That triggered many emails and more analysis today.  After the day’s work we come away even more concerned.

We wrote: “The minimum bid in the most recent auction (April 21) was 2.05%.  In the previous auction (April 7) the minimum bid was 2.11%.   In the most recent auction the stop out rate which was awarded to all bidders was 2.87%.  In the previous auction the awarded rate was 2.82%.   So the minimum bid went down while the award rate went up.  The spread widened by 11 basis points.  That is not suggestive of a market returning to normalcy.”

We added: “Remember that this auction occurs when the Discount Window rate is 2.5% and when the targeted Fed Funds overnight rate is 2.25%.  And it is important to understand that the minimum bid specified is a market based price of the expected Fed Funds rate over the 28 day term.”

Today we delved further and concluded that it is worse than we thought.   We explored the issue of why banks knowingly bid 2.87% of more to borrow $50 billion when they could have borrowed it from the Discount Window at 2.5%.   We asked colleagues, former Fed officials, journalists, academics in banking and skilled practitioners.  No one could offer a clear explanation of why banks would pay more than they had to. 

The only consistent comment was that banks chose not to go to the Discount Window because it had a “stigma” attached to it.  Stigma?  Really!  Banks will pay more to avoid a “stigma” when the Fed has specifically said there is no stigma attached. 

Let’s dissect the cost of this stigma. 

Remember the TAF stop out rate is the lowest rate that clears the auction.  We do not know the range of bids.  We only know that it took the 2.87% rate to clear the $50 billion.  Anyway we will use the 2.87% rate in this analysis. 

When the auction occurred the Discount Rate was 2.5%.   So our initial calculation was that the banks had collectively paid 37 basis points above the Discount Rate to use the TAF instead of the Discount Window.  

We say “instead of” because the same collateral is used for the TAF as is used for the Discount Window.  The procedure is the same and each bank would deal with the same regional Federal Reserve Bank for either TAF or Discount Window borrowing.  In fact, the TAF rules allow that excess collateral posted for the TAF can be used for the Discount Window.   So in the collateral department the issue is “apples and apples.”

Ok.  Why the 37 basis points?   We can find no concrete answer.  Only Stigma.

How much is the cost of this stigma?

Well you could simply take 37 basis points times $50 billion for 28 days.  That would be the easy way.   But we think that is not enough. 

Remember the minimum bid was 2.05% based on the swap rate for Fed Funds.  That means the expectation in the market was for an interest rate cut.  Therefore the minimum bid was set 20 basis points below the targeted Fed Funds rate.   Now we know that the Discount Window rate is a penalty rate and is 1/4 of 1% higher than the Fed Funds rate.  But we can reasonably assume that if the Fed Funds rate is cut to 2% at the end of this month, the Discount rate will also be cut.   Thus the expected Discount rate is 2.25% if the expected Fed Funds rate is 2%.

Therefore we conclude that a better reference for the minimum bid adjusted Discount rate is 2.3%.  We add the 25 basis point penalty to the 2.05% minimum to get this number. 

This means that banks actually incurred an expected additional cost of 57 basis points on $50 billion for a 28 day loan.  

Now to the computation of the annualized systemic cost of stigma. 

The present TAF size is $100 billion with $50 billion rolling every two weeks.   Let us assume the 57 basis point cost of stigma is constant.  We know that is not the case and that this spread is volatile but we will use 57 basis points to measure the running cost because it is the most recent pricing and is discernable from the recent TAF auction. 

We also know that if the Fed does its job the stigma will disappear.   That means the stigma exists in spite of what the Fed says and therefore it reflects the Fed’s failure to cure the stigma. 

57 basis points on $100 billion over the course of a year is $570 million.  That is $47.5 million a month.  In other words, the failure of the Fed to remove the stigma it says it doesn’t want and denies that it is imposing is costing the US banking system $48 million a month. 

It is incumbent on the Governors of the Federal Reserve to remove this “stigma tax” once and for all.  The banking system can use the money for its rehabilitation. 

This simple analysis raises many additional questions.  It suggests that the true cost is much higher.   Banks that are rolling TAF must rebid or pay off.  Do they raise bids in order to insure that they can roll their loans?  Are banks becoming more impaired from the stigma cost.  Where is the transparency that explains this stigma? 

We will stop here for tonight.  It has been a long day.   We must specifically thank the many readers who emailed us and those who helped us vet this stigma cost estimate.  All errors are ours.