By Scott Lanman
May 2 (Bloomberg) -- The Federal Reserve increased its auctions of cash to banks and expanded the collateral it takes on from bond dealers, acting in concert with European central banks to alleviate persistent strains in credit markets.
The Fed boosted its biweekly Term Auction Facility operations by 50 percent to $75 billion. It also raised the amount of dollars it makes available to the European Central Bank and Swiss National Bank through swap lines to a combined $62 billion from $36 billion.
Today's actions follow a jump in banks' borrowing costs of as much as 0.38 percentage point since the Fed's March meeting that had blunted the impact of the cash injections that began in December. An index of U.S. financial stocks climbed to the highest level in three months after the announcements.
``The world is awash in liquidity, it just isn't reaching the right financial borrowers,'' said Chris Rupkey, chief financial economist at Bank of Tokyo-Mitsubishi UFJ Ltd. in New York. ``Today's action from the central banks is another strong dose of medicine that will help cure what ails the credit markets.''
Fed officials also expanded the collateral they accept under the Term Securities Lending Facility to include AAA rated asset- backed investments. That includes some bonds backed by student loans, which Democrats in Congress had pushed Chairman Ben S. Bernanke to take on the central bank's balance sheet.
New Tools
The Fed created the Term Auction Facility and two other programs to reverse a decline in liquidity that began last year with the collapse in the market for subprime mortgages. Today's move may reduce loan payments for some companies and homeowners with variable-rate mortgages.
Today's actions were taken ``in view of the persistent liquidity pressures in some term funding markets,'' the Fed said in a statement.
A gauge of bank funding costs, a premium on three-month bank loans over the overnight indexed swap rate, which is a measure of what traders expect for the Fed's benchmark rate, reached 87 basis points on April 21. That was the highest since the Fed announced the TAF on Dec. 12.
Speculation had risen among Fed watchers this week that the central bank would increase the size of the TAF operations after borrowing costs increased. Some had also anticipated an extension in the term of the loans beyond 28 days.
`Tremendous Reluctance'
``It was a relatively conservative measure'' because the duration remains unchanged, Richard Iley, senior economist at BNP Paribas SA in New York, said in an interview with Bloomberg Television. ``Evidence thus far is that these auctions have had very limited impact in bringing down these still-elevated credit spreads. There still remains a tremendous reluctance on the part of financial institutions to lend to one another.''
The TAF, which provides 28-day loans to commercial banks, will sell $75 billion in auctions every two weeks, starting with the May 5 operation, the Fed said in the statement. The decision will increase the amount outstanding under the auctions to $150 billion from $100 billion.
It's the third increase since the program started in December at $40 billion per month.
``They're trying to prevent the strains from building up,'' said John Silvia, chief economist at Wachovia Corp. in Charlotte, North Carolina. ``They're looking for ways to provide liquidity other than through cutting the federal funds rate.''
TSLF Operations
The expanded collateral under the TSLF will take effect with the sale to be announced May 7 and settle on May 9, the Fed said. The Fed announced the program in March, auctioning as much as $200 billion in Treasuries. In several of the sales, the Fed has failed to attract enough bids to cover the securities at auction.
The Fed already accepts residential and commercial mortgage- backed securities and agency collateralized mortgage obligations through the TSLF.
``The wider pool of collateral should promote improved financing conditions in a broader range of financial markets,'' the Fed said.
Along with its efforts to revive liquidity, the Fed has lowered its target rate for overnight loans between banks by 3.25 percentage points since September. Even with economic growth faltering, the Fed signaled on April 30 it may pause after seven interest-rate cuts. The central bank didn't rule out other actions aimed at making it easier for banks to borrow.
Borrowing Costs
The TAF is one of several Fed initiatives to unblock credit markets, along with direct loans to investment banks and $29 billion of financing to secure JPMorgan Chase & Co.'s takeover of Bear Stearns Cos. Investors have responded, buying a record $45.3 billion of corporate bonds last week and spurring a rebound in the Standard & Poor's 500 stock index from the year's low in March.
The central bank last increased the TAF in March from its previous $60 billion a month. The central bank originally set the auctions at $40 billion a month in December, expanding them the following month.
Rates at last month's TAF auctions were 2.82 percent and 2.87 percent, above the then-2.5 percent rate on direct loans through the discount window. This ``seeming anomaly'' of the higher rate may have resulted from banks' willingness to pay a premium to avoid any stigma from discount-window borrowing, Boston Fed President Eric Rosengren said in an April 18 speech.
Today's decision comes after criticism from Stanford University economist John Taylor, who wrote in a study last month that there is ``no empirical evidence'' the TAF has reduced the premium that banks charge each other to lend cash for three months.
Fed Governor Frederic Mishkin said in a Feb. 15 speech that there was ``some evidence that the TAF may have had significant beneficial effects on financial markets.'' Mishkin included the caveat that ``isolating the impact of the TAF on financial markets is not easy.''
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