FYI | Aug 18 2007
By Greg Peel
Friday’s Federal Reserve Statement:
“Financial market conditions have deteriorated, and tighter credit conditions and increased uncertainty have the potential to restrain economic growth going forward. In these circumstances, although recent data suggest that the economy has continued to expand at a moderate pace, the Federal Open Market Committee judges that the downside risks to growth have increased appreciably. The Committee is monitoring the situation and is prepared to act as needed to mitigate the adverse effects on the economy arising from the disruptions in financial markets.”
“To promote the restoration of orderly conditions in financial markets, the Federal Reserve Board approved temporary changes to its primary credit discount window facility. The Board approved a 50 basis point reduction in the primary credit rate to 5-3/4 percent, to narrow the spread between the primary credit rate and the Federal Open Market Committee’s target federal funds rate to 50 basis points. The Board is also announcing a change to the Reserve Banks’ usual practices to allow the provision of term financing for as long as 30 days, renewable by the borrower.
“These changes will remain in place until the Federal Reserve determines that market liquidity has improved materially. These changes are designed to provide depositories with greater assurance about the cost and availability of funding. The Federal Reserve will continue to accept a broad range of collateral for discount window loans, including home mortgages and related assets. Existing collateral margins will be maintained. In taking this action, the Board approved the requests submitted by the Boards of Directors of the Federal Reserve Banks of New York and San Francisco.”
It was only ten days earlier that Fed chairman Bernanke declared the US economy sound and inflation still the primary concern. In ten days the credit crunch – in which lenders withdrew support from high-risk asset classes – became a liquidity crisis – in which lenders became so panicked they would not support even prime mortgage and commercial paper. The next potential step from the liquidity crisis is a solvency crisis, and that was not something the Fed was prepared to allow. The risk had now become a deflationary environment and an economic recession.
To date the Fed had attacked the problem (as had central banks around the globe) by treating it as a temporary loss of liquidity in the inter-bank system. It injected billions into the overnight money market in a move which it hoped would encourage banks to extend credit to non-bank institutions which were facing the inability to rollover financing on even their quality debt portfolios. While the Fed target cash rate has remained at 5.25%, the actual overnight market rate had fallen to as low as 4.5%. By not actually cutting the target rate, the Fed was maintaining a level of uncertainty. If these injections were intended only to be a band-aid, then there was no rush to take the risk on lending to non-bank institutions. The 90-day T-bill rate fell from 5% to as low as 3.3% as money flowed not to where it was needed, but to government-backed safety.
America’s biggest non-bank home lender – Countrywide – can be seen as representative of the problem facing the US financial system. Countrywide is not weighed down with subprime mortgages. The majority of the lender’s mortgages are of prime quality. Yet as liquidity dried up, Countrywide was forced to go cap in hand to banks to provide any sort of financing to save its mortgage portfolios. There was a very real risk Countrywide would go under.
The Fed’s primary credit “discount window” facility, as described in the second paragraph of the statement above, is a means for the Fed to lend money directly to qualifying institutions as opposed to injecting liquidity into the inter-bank market and expecting the banks to do the rest. Since 2003, the term “discount window” has in fact been a misnomer. Before this time the Fed would lend money to banks in distress at a discount to (lower rate than) the Fed funds rate. The intent is logical – if you’re in distress then you really need a cheap loan, not an expensive one. This is where the central bank becomes truly the “lender of the last resort”. Lending cheaply to a distressed borrower is not sound commercial practice, but if it prevents thousands or millions of US citizens losing their life’s savings or losing their houses then it is what an elected government is there to do.
However, while honourable in intent the discount window became self-defeating. If a bank were to go to the window it is, by implication, admitting a problem. The result is just as likely to be a further run on funds. The discount window was seen to have a “stigma” attached.
So in 2003 the Fed decided to go the other way, and turn the discount window into a “premium window” by definition, just not by name. Until Friday morning banks could go to the Fed and borrow funds at 100 basis points above the target cash rate – in this case 6.25%. This helped to alleviate some of the stigma, as if a bank were to go to the window it still indicated a problem of sorts, but not one so dire as to require a cheap-fund bailout.
On Friday, as the above statement notified, the Fed cut the discount window margin from 100 basis points to 50 basis points. Qualifying institutions could now borrow at 5.75%. It also pushed out the life of such rescue funding to 30 days. Perhaps most importantly, it relaxed its previous requirement for AAA government paper as collateral to include AAA home mortgages and “related assets”.
This move could be construed analogously as “saving Countrywide”.
From the stock market’s point of view, this was real action from the Fed, not uncertain action. From the opening bell the Dow jumped 322 points as a wave of short covering swept into the bourse, exacerbated by the expiry of index options. Once expired, the market fell into a hole again but that’s when the phalanxes of buyers marched into the market and the Dow rose steadily throughout the remainder of the day, closing up 233 points, or 1.8%. The “real” stock market indicator – the S&P 500 – rose 2.5%. The Nasdaq was up 2.2%.
The bounce was also felt in Europe, where the FTSE rose 3.5%. Japan will be hoping the sentiment will reach across the Pacific as well. The Nikkei fell over 5% on Friday – the biggest fall since the 2000 tech-wreck. Japan’s markets are feeling the brunt of carry trade unwinding, as well as the credit issue, but the Fed move managed to halt the yen’s rapid rise on Friday night. The Fed’s move is negative for the US dollar, which fell against the euro and pound, but a sharp halt in the carry trade unwind allowed the US dollar to pick up some ground against the yen. This was also positive for the Aussie dollar which, after looking like it was about to go through US$0.78, rebounded to US$0.7963.
It also allowed gold to recover some lost ground, as all commodities recovered lost ground. In gold’s case, you could say gold was acting as a commodity and/or a currency, as Fed lending from the discount window is immediately inflationary. Gold rose US$3.90 to $656.30/oz. Base metals had somewhat of a bounce, although early gains were pared back by the end of trading. On the LME, copper was up 3%, nickel 4% and zinc 2%.
Oil was also up in sympathy, rising US98c to US$71.98/bbl, but in oil’s case we are still very much on a weather-watch. While tropical storm Erin was downgraded when it crossed the coast on Thursday, tropical storm Dean is still out in the Caribbean looking ominous.
The SPI Overnight rose 190 points.
But coming back to the matter at hand, why has the Fed invoked “the moral hazard”?
It is a moral hazard because many see the move as “Main Street bailing out Wall Street”. Not only has the Fed lowered the discount rate, but the market is now all but certain the Fed will have to ease the target cash rate – at least by the next FOMC meeting on September 18, but quite possibly in an emergency meeting earlier.
The implication is that the Fed has thrown the lifeline to those institutions and investors who got themselves into trouble through their own sheer greed. “Saving the rich”, you could say. To offer up as much money as the banking system needs to avoid a solvency crisis, the Fed must shift the printing press into another gear. This reduces the value of the US dollar, and hence the purchasing power of all Americans. Thus – Main Street bails out Wall Street. To make matters worse, the Fed may also ease. It was a too-easy monetary policy that got us into this mess in the first place.
But the Fed would not see it this way. Up until Friday the intention was made clear at least by St Louis Fed governor Poole, and indirectly by George Bush, that there would not be a Wall Street bailout. Risky credit had to be expunged from the market and if that caused losses for the rich, so be it. Ultimately the economy is modestly healthy and inflation is still the primary concern. The Fed has still not lowered the target cash rate from 5.25%, even though cash is actually trading at 4.5% following massive liquidity injections.
But Friday’s statement indicated that the Fed now saw an emergency situation. What it foresaw was the ongoing freezing of credit, insolvencies, and the potential to head into recession. A recession would lead to no consumer spending, lost jobs, and further cascading mortgage defaults. A recipe for a big downward spiral. In “bailing out” Wall Street the Fed would see it as protecting Main Street as well.
There is still talk of raising the investment limit on the two government sponsored mortgage lenders Fannie Mae and Freddie Mac. In so doing, mortgages in excess of US$400-600,000 could be issued, allowing what is realistically a large demographic of the comfortable (but not just the super-rich) to refinance prime mortgages that may come under threat if a Countrywide-type lender were to go down. The government is so far staunchly resisting such a move, but it now seems the playing field has changed.
Has the Fed made the ultimate move (particularly if it also cuts the target rate as expected) that will restore order to the markets and allow the Dow to return to 14,000?
Yes, say the bulls. No, say the bears. The bears (and here we must also include short term bears who are looking for a buying opportunity further down the track) still see this as another temporary fix that may yet have to be repeated and may yet not prevent further turmoil. We still do not know who will survive and who will go down.
What it will perhaps achieve is a restoration of confidence that the Fed is ready to do what it has to and take the drastic steps to save the US economy (despite the negative effect on the US dollar). Central banks are always accused of being behind, rather than in front of, the curve, and as such Friday’s move is seen by many as positive but tardy. If markets remain volatile, and further losses are experienced, it will act again. Thus a prudent investor will not immediately see Friday as the turning point. That point might be a month or more off just yet.
For readers who like to study the tea-leaves for past indicators of future events, a look at the presentation at http://www.goodmorningwallst.com/files/gmws072507/gmws072507.html is recommended.
