Primary Dealer Credit Facility (US)

By late 2007, problems in the subprime mortgage market began to spread into the interbank lending markets and panic grew, resulting in a contraction in some types of lending, particularly term lending. Primary dealers, which are the securities firms that trade with the Federal Reserve in order to implement monetary policy, were particularly dependent on tri-party repurchase agreements (repos) for their funding. As term funding became more expensive, outstanding overnight tri-party repurchase agreements by primary dealers grew to a peak of $3 trillion in March 2008, the equivalent of 75% of total primary dealer financing, reflecting significant rollover risk. Furthermore, lenders were worried about the risk of the collateral they were buying, especially the mortgage-backed securities, resulting in rising haircuts, even for safer collateral such as Treasuries. The risky collateral brought risk into the market and increased the chance of a repo run (as would impact Bear Stearns), which then could lead to sales of securities at depressed prices (Adrian, Burke, and McAndrews 2009).

The Fed’s earlier programs were limited to providing liquidity only to depository institutions, and there was no guarantee that the liquidity provided to these depository institutions would be passed on to primary dealers. Therefore, the Federal Reserve sought to provide liquidity directly to primary dealers.

On March 7, the Fed introduced a single-tranche open-market operation that allowed primary dealers to borrow at a 28-day term—much longer than its typical overnight loans—using traditional open-market operations (OMO) collateral (see separate note). However, that program accepted only high-quality collateral. On March 11, 2008, the Federal Reserve Board announced the Term Securities Lending Facility (TSLF), which allowed participants (primary dealers) to exchange less-liquid collateral for Treasuries, which would be acceptable as repo collateral. However, the TSLF’s first auction would not be held until March 27, 2008. In the days following Bear Stearns’s near failure, additional liquidity strains were observed in the repo market, and the Federal Reserve Board grew concerned that other primary dealers might face runs on their liquidity, as Bear had. It was also concerned about the risk that the clearing banks were facing at the increased possibility that a major financial institution might fail. The clearing banks held borrowers’ collateral overnight on behalf of repo lenders—typically short-term investors, like money market mutual funds—which lent cash overnight. But during the day, the clearing banks “unwound” the trades, returning cash to the lenders and collateral to the borrowers—and essentially lending their own cash to the borrowers. If a clearing bank chose not to unwind a borrower’s trades out of concern it might default during the day, all of its repo lenders would be left holding collateral that they then would be forced to sell quickly, flooding a depressed market (Adrian, Burke, and McAndrews 2009). Thus, the Fed sought to provide a more immediate and direct solution (GAO 2011).

At the height of the Bear Stearns crisis, the Federal Reserve worked continuously over the weekend of March 15-16 to create a facility that could assist primary dealers with funding in the event that Bear Stearns filed for bankruptcy (OIG 2010). The Federal Reserve Board granted the Federal Reserve Bank of New York (FRBNY) the authority to establish the Primary Dealer Credit Facility (PDCF), announced on March 16, 2008, to “improve the ability of primary dealers to provide financing to participants in securitization markets and promote the orderly functioning of financial markets more generally” (Federal Reserve 2008).

The PDCF was established under the Fed’s powers granted to it under Section 13(3) of the Federal Reserve Act, which allowed it to act as a “lender of last resort” to nonbanks in “unusual and exigent circumstances” and if the borrower was unable to attain other means of credit. Any loans made under Section 13(3) had to be secured to the satisfaction of the lending reserve bank.

The PDCF provided overnight secured loans to primary dealers. To carry out this mission, the PDCF utilized its existing operational relationships with the primary dealers and the tri-party repo system that it used for its OMO repo operations and in which JP Morgan Chase & Co. and Bank of New York Mellon were the two tri-party repo clearing banks (GAO 2011). This enabled the Fed to make the PDCF operational just one day after announcing it.

To participate in the PDCF, primary dealers signaled a request for an overnight loan to their clearing banks, usually before 5 p.m. ET on a business day. Once the clearing bank confirmed that a sufficient amount of eligible collateral had been pledged to cover the loan, it would price the pledged collateral and apply a haircut. The clearing bank would proceed to notify the Federal Reserve Bank of New York (FRBNY), which would then also acknowledge that the primary dealer had pledged a sufficient amount of margin-adjusted eligible collateral. The FRBNY would then transfer the loan amount to the clearing bank for credit to the primary dealer’s account. This process is illustrated in Figure 1.

Loans made under the PDCF were collateralized but also made with recourse, ensuring that the primary dealer was responsible for repayment even if the collateral lost value overnight.

Initially, eligible collateral for the PDCF was restricted to collateral that was eligible in the Fed OMOs; investment-grade securities, including corporate bonds; municipal securities; and asset-backed securities (ABS), including mortgage-backed securities. In September 2008, eligible collateral was expanded to match all types of collateral eligible in the tri-party repo system, which included some noninvestment-grade securities, equity securities, and whole loans.

For collateral eligible in OMOs, haircuts assigned were equivalent to haircuts under the OMOs. For collateral not eligible in OMOs, haircuts were determined by the asset’s risk and were generally higher than those under OMO standards. The PDCF was designed to last six months, subject to extension based on market conditions.

PDCF operations were published in a weekly (Federal Reserve’s H.4.1 weekly statistical release, Factors Affecting Reserve Balances of Depository Institutions and Condition Statement of Federal Reserve Banks) and monthly (Credit and Liquidity Programs and the Balance Sheet) release on the Federal Reserve Board’s public website (OIG 2010). Only broad numbers were reported, such as the average daily loan size for the week. The names of specific borrowers were not disclosed in order to protect borrowers from stigma associated with relying on the Fed for loans. The Fed hoped that this level of anonymity would encourage participation in the program. In December 2010, the Fed released PDCF loan details, along with details from its other emergency lending programs, in accordance with the new requirements of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010.

The funding and management of the PDCF was conducted by the FRBNY. However, the Federal Reserve Bank of Chicago (FRB-Chicago) and the Federal Reserve Bank of Atlanta (FRB-Atlanta) provided operational assistance in implementing the PDCF (OIG 2010).

The PDCF terms did not impose a borrowing limit for any individual primary dealer. Therefore, the amount of funding that any primary dealer could borrow under the PDCF was limited only by the amount of haircut-adjusted eligible collateral that such a primary dealer could present to its clearing bank. However, the PDCF did originally impose a frequency-based penalty fee on primary dealers that accessed the facility on more than 30 days out of any 120 days (OIG 2010).

On February 3, 2009, the facility frequency usage fee changed, so that fees were calculated based on use of the facility for more than 45 business days out of the preceding 180 business days. The fee would increase up to 40 basis points (annualized rate) as the primary dealer continued to access the facility past the 45-business-day mark (OIG 2010).

The PDCF also did not specify an overall funding limit, as some Fed programs did. In this way, it was similar to the Federal Reserve’s discount window in that it served as a backstop source of liquidity for primary dealers during market disruptions. Before the creation of the PDCF, primary dealers that were not depository institutions had no access to a “lender of last resort” credit facility.

Affiliates of foreign banks, such as Barclays, BNP Paribas Securities, Daiwa Securities America, Deutsche Bank Securities, and UBS Securities LLC, that operated in the US as primary dealers were eligible to utilize the PDCF, and they did (Reuters 2010). The disclosure of just how much these foreign-related entities borrowed from the facility became a point of contention in public perception (Reuters 2010). However, on an aggregate basis, dealers with European parents were often heavy borrowers from the TSLF but very light borrowers from the PDCF. Royal Bank of Scotland (RBS), for example, borrowed from the TSLF on 57 occasions but never borrowed from the PDCF (Achayra et al. 2014).

The PDCF was immediately popular, as seen in Figure 2. In its first week, the PDCF extended loans to 10 primary dealers. During its first three weeks, borrowing averaged over $30 billion per day and then peaked at $40 billion per day in March 2008 before gradually declining to zero in July, where it stayed until September. Bear Stearns was consistently the largest PDCF borrower until its purchase by J.P. Morgan Chase in March 2008 (Achayra et al. 2014; GAO 2011; Adrian, Burke, and McAndrews 2009). 

Borrowing spiked shortly after the Federal Reserve expanded eligible collateral following the Lehman bankruptcy filing. The expanded collateral included all of the types of instruments that could be pledged in the tri-party repo systems of the two major clearing banks, which included equity securities and whole loans.

Lending rose to $59.7 billion on September 17, and peaked at $130 billion on September 26, 2008, in just PDCF loans. Including loans to London affiliates (London loans), as discussed below, the peak was $156 billion reached on September 29, 2008, the day Congress rejected the administration’s first proposed bank bailout bill (GAO 2011). Following those events, as market conditions improved, usage of the facility gradually declined to zero in May 2009.

In total, 18 of the 20 eligible primary dealers ultimately utilized the facility, and the Federal Reserve made 1,021 loans under the PDCF, with the five largest borrowers accounting for 82.5% of all PDCF loans, as shown in Figure 3 (Adrian and Schaumburg 2012, GAO 2011). The biggest borrowers overall were Citigroup, Morgan Stanley, and Merrill Lynch, with each borrowing over $1 trillion in loans. Of course, these figures represent the sum of multiple overnight draws. The largest single loan, of $47.9 billion, went to Barclays Capital on September 18, 2008, the day after Barclays agreed to buy most assets of Lehman Brothers’ US broker-dealer (Reuters 2010). Including London loans, the largest PDCF borrowing for a firm at one time was by Morgan Stanley, which had a total of $61.3 billion outstanding through the PDCF on September 29, 2008, about one-third of which was through London. Notably, Citigroup borrowed into April 2009, and Bank of America took out its last loan in May 2009; both banks had received other targeted assistance from the government (Reuters 2010).

        Dollars in billions

Source: GAO 2011

Note: Total borrowing for J.P. Morgan Securities reflects consolidation of total borrowing by Bear, Stearns & Co., Inc. after the acquisition was completed. Amount shown for Bank of America Corporation reflects consolidation of total borrowing by Merrill Lynch and Countrywide following the completion of those acquisitions.

Acharya et al. (2014) found that many firms that borrowed heavily from the TSLF also borrowed heavily from the PDCF. Other findings by Acharya were that companies that pledged greater shares of equity to the TSLF tended to be heavy borrowers at the PDCF, suggesting that the expansion of collateral to include equity in September created a strong incentive for dealers to borrow at the PDCF. Moreover, dealers that pledged large proportions of equity at the PDCF also pledged large proportions of other risky assets, such as MBS/CMOs, ABS, corporate securities, and municipal securities at both the PDCF and TSLF (Achayra et al. 2014).

Notably, despite the Fed having greatly expanded liquidity resources for banks, bank-affiliated primary dealers also heavily borrowed from the PDCF, as can be seen in Figure 4.