Friday, August 17, 2007
The Fed Cut The Bank Discount Rate
Update: And the dollar promptly started to fall. The Fed doesn't want a really strong dollar, because a weaker dollar is helping manufacturing. On the other hand, a stronger dollar is bringing money into the US. The safe haven premium is necessary to some extent because it allows the Fed to fight inflation by cutting interest rates in one way or another without generating an exodus of money. So the Fed is walking a narrow line. End update.
See Oraculations' explanation.
What they did:
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.This change reduces the cost to banks to obtain financing, and ensures that it will be extended. It does not reduce the overnight rate, but recent actions have pushed the effective overnight rate below its target. The plea raised in recent days to get the Fed to accept non-agency MBS appears to have been ignored, but the Fed could quietly change that at any time. The Fed is encouraging banks to use the discount window.
The Fed is trying to prevent the flow of financing to borrowers with good credit from being cut off, thus depressing economic activity a la the 80's. In the last couple of days non-agency loan underwriting has been very restrained. It is not clear whether this Fed action will change that very much, but it will generate a resurgence in the stock market at least in the short term, thus hopefully stopping some of the bleeding.
The real problem for lending going forward is collateral valuation and the resurgence of risk-based underwriting. In practice, this means that lenders want downpayments on many new loans. The day of the 100% stated is pretty much over, and if any are written they will be done in only a few very restricted cases.
In terms of the overall economy, credit lines and home equity loans are often used as credit sources for small businesses, which generate a large hunk of new jobs. No matter what the Fed does, the current situation will have some repressive effect on growth.
The odds are that home prices in bubbly areas (defined as areas in which the median home price/median income ratio has been sharply skewed upward) will start to drop like a rock. Some of them have already been doing so. See Housing Tracker, and note the sudden declines of the last couple of months.
I agree with Tanta's theory that the huge wave of ARM resets will be somewhat countered by modifications of the margins and/or other loan terms wherever it is workable. This could cut expected default rates by 25% or so. Keeping index rates like LIBOR (London Interbank) down will be a battle.
Real mortgage rates are still below the historical average. It is risky loans that are seeing rises in rates, and that is a necessity for restoring the functioning of the market. So the Fed's bias must be toward restraining inflation; rising inflation expectations would boost all rates and produce a much worse situation. Unfortunately, pipeline inflation is still quite high and may even be increasing.
Both cutting interest rates and injecting money will feed the fires of inflation. If the FED were serious about inflation, it would raise interest rates. It can't do that because of housing. We are addicted to credit and cheap credit as much as a Meth addict is addicted to Meth.
Taking a strong line on inflation generally will allow the dollar to remain something of a safe haven. The Fed basically must stay in step with Bank of England.
Whether prime mortgage rates move or not (and they won't be affected by Fed cuts directly), the effective cost for all riskier lending has risen dramatically and will not be addressed. That is deflationary in the extreme. Watch housing prices fall in areas with disproportionate median price/income ratios compared to historical norms.
I think this is aimed at Countrywide and maybe one or two others. They will give the better quality loans they got stuck with as collateral and get cash.
Of course i could be 100% wrong as I do not hold a PhD in finance.
Yes, the borrowing creates money and I heard about the call. But the truth is that the borrowing doesn't create any more money (and really less) than would have been produced if the financing had occurred through the normal route. The Fed is only going to accept reasonably good stuff, so this is a measure to prevent a dead halt to the merry-go-round, rather than the sudden infusion of sums of ersatz money or creation of money for collateral that's really trash.
I wondered if the Fed didn't make the call to ensure that the hedgies don't look at any use of the discount window now as a signal to short the heck out of the borrowing entity. Maybe I'm wrong, but my guess is that few banks will use it even so. Bankers are creatures of habit.
The question is whether the discount window move was aimed at saving Countrywide or saving the system from Countrywide.
I'm not sure about saving Countrywide. The lender's problem is they have short term paper due on funded loans they can't sell. The loans have not been securitized. Can they securitize them for the sole purpose of a Fed repo transaction?
They could also repo whatever MBS is on the books in their "held for investment" account. Haven't looked, but again, doesn't seem like a solution to the problem of liquidating the "held for sale" account.
I'm sure the Fed could be creative and figure something out. Does it want to save this company? Only for reasons of systemic stability. But that's where the discount window comes in: if Countrywide defaults on its short term paper, other banks would experience liquidity problems. The discount window would be there, ready and waiting, to backstop their problems.
So, intended to save ailing institutions, or save healthy ones? Which do you think?
On second thought, Countrywide Bank is probably okay. Its the non-depository that's in trouble with its commercial paper and credit lines. I don't believe they can even borrow through the discount window. So a failure of the non-depository would be "firewalled" by giving Countrywide Bank ready access to discount window fund. Otherwise, the run on Countrywide Bank would reverberate throughout the banking system.
So maybe its both: save the bank, protect the system from the failure of the non-depository.
As for saving the system from Countrywide, the truth is that if it did fail absolutely, an utter nightmare would ensue. The first problem is that they are a huge, huge servicer. The second is that if a run on that bank succeeded, runs on several others would surely follow.
Since Countrywide is pulling their mortgage origination operation back under the bank, the entire operation will now be subject to regulatory scrutiny by well-experienced bank examiners. This is a good thing.
I don't like Countrywide for reasons that I don't want to discuss, but I do view this move by the Fed as deeply rational.
Everyone should be aware that the problem is not in just short term Asset Backed Commercial Paper (ABCP) but in all of it. The reason why we have a crisis with short term is that the short term came up for renewal already. As this wears on, each successive term will be hit.
Utter speculation here, but if I were the Fed I'd be:
1) lining up a AAA buyer for the servicing unit.
2) letting the non-depository fail.
3) making sure I had a contingency plan to prevent a run at the bank.
Countrywide plans to put mortgages under the bank, but I don't think it can just snap its fingers and transfer the Held for Sale loans just like that. The bank would need lots of funding to "buy" them. More likely the securitization business is toast, and the rest will hopefully be saved.
The servicing operation is huge. I doubt there is the capacity elsewhere to take it on at this juncture. They've got servicing of their own loans and other purchased servicing rights. It is organized as a separate company, which should still be profitable.
I'm not speculating as to what will happen with the entire business, but I do think that the size of the servicing operation is a problem. According to Mortgage Daily in July, Countrywide was still the second largest servicer in the country.
If a failure of the company occurred in non-crisis times, it would be a big event but it would also draw other large industry players. I'm not sure that an entire cash-short industry can deal with this right now.
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