GC Tsy changes post announcment

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I’m mainly interested in LIBOR over the turn as an indicator or how the new international facility is doing.

Also watching to see when higher oil means higher inflation and higher rates, vs. higher oil currently meaning econ weakness and lower rates. Maybe next week after this weeks inflation numbers are out.

GC has lost some of it’s flight to quality bid on term repos. The market is higher across terms as a result of the treasury announcement. Expectations of future rate cuts have not been priced out of the market I will follow up shortly with an AGCY and MBS runs.

GC TSY Last Night Now Change
O/N 4.60 4.23 -0.37
1wk 4.12 4.12 0
2wk 4.03 3.95 -0.08
3wk 3.7 3.75 0.05
1mo 3.7 3.76 0.06
2mo 3.68 3.74 0.06
3mo 3.63 3.71 0.08
6mo 3.62 3.67 0.05
9mo 3.52 3.56 0.04
1yr 3.42 3.46 0.04

* 1wk – 2wk seasonal add need “window dressing” balance sheets

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Fed regs with comments

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Note they’ve also added the international arrangements as per my discussion earlier today.

The same recommendations suggested in August.

7 Lending by the Federal Reserve

The Federal Reserve’s authority to extend loans is a potentially powerful tool with

which it can stimulate aggregate demand. Loans to depository institutions can help spur credit extensions to households and firms. If depository institutions are unwilling or unable to lend to firms and households, direct loans by the Federal Reserve to firms and households could provide the financing needed for economic recovery- although such lending is subject to the restrictions discussed below.

The above has the causation backwards. In the banking system, loans ‘create’ deposits, which many incur reserve requirements.

In the first instance, new reserve requirements are functionally an ‘overdraft’ in the bank’s reserve account at the fed. Since an overdraft *is* a loan, as a matter of accounting loans create both deposits and any resulting new required reserves. What the fed does is set the price of the reserves (the rate of interest), which influences bank lending decisions, but doesn’t directly control bank lending.

Therefore, all fed lending to member banks is generally to replace ‘overdrafts’ in reserve accounts. At the end of each statement period, overdrafts are booked as loans from the fed’s discount window, which are 50 bp over the fed fund rate and also carry a ‘stigma’ of implying the bank is having financial difficulties. That’s why banks are willing to bid up funds above the discount rate when trading each other,

7.1 Lending to Depository Institutions

As shown in table 7.1, lending to depositories is authorized under several sections of the Federal Reserve Act: Advances are authorized under sections 10B, 13(8) and 13(13), while discounts are authorized under sections 13(2), 13(3), 13(4), 13(6) and13A.78 In recent decades, the Federal Reserve has extended credit to depositories only through advances (under sections 10B and 13(8)) and has not made any discounts. The broadest and most flexible authority under which the Federal Reserve can extend loans to depositories is Section 10B, under which the restriction on collateral is only that the Reserve Bank making the advance deems the collateral to be “satisfactory”.

Yes, and this makes perfect sense. All bank collateral is limited to what the federal regulators deem ‘legal’ along with regulated concentration and gap limits. Also, banks can issue federally guaranteed liabilities; so, functionally the government is already funding what they deem legal assets. So, for the fed to provide another channel for this process, to assist ‘market functioning’, changes nothing of substance regarding risk for the government.

The collateral can be promissory notes, such as corporate bonds and commercial paper- instruments that cannot be purchased by the Federal Reserve.

But, as above, instruments that are categorized as bank legal by federal regulation, and can already be funded via government insured deposits.

Currently, Reserve Banks accept as collateral various types of promissory notes of acceptable quality including state and local government securities, mortgages covering one- to four-family residences, credit-card receivables, other customer notes, commercial mortgages, and business loans. Apparently, even equity shares would be legally acceptable as collateral if a Reserve Bank found them to be acceptable as collateral.

78The differences between discounts and advances are discussed briefly below and in more detail

in Section 2.1 of Small and Clouse (2000).

59

Table 7.1

Credit Instruments Used in Discounts or Advances

Borrower Credit Instrument

Depositories

10B Advances* Depository’s time and demand notes secured \to the

satisfaction of [the] Reserve Bank.” * *

13(8) Advances Depository’s promissory note secured by U.S Treasury,

U.S.-guaranteed, U.S. agency, or U.S. agency-guaranteed

securities, or by credit instruments eligible for discount or purchase.

13(2) Discounts * * * Notes, drafts and bills of exchange meeting \real bills” criteria.

13(4) Discounts * * * Bills of exchange payable on sight or demand which grow out of the shipment of agricultural goods.

13(6) Discounts * * * Acceptances which grow out of the shipment of goods

(section 13(7)) or for the purpose of furnishing dollar exchange as required by the usages of trade (section 13(12)).

13A Discounts * * * Notes, drafts, and bills of exchange secured by agricultural paper.

IPCs * * * *

13(13) Advances IPC’s promissory notes secured by U.S. Treasury, U.S. Agency or U.S. agency-guaranteed obligations.

13(3) Discounts Notes, drafts, and bills of exchange endorsed or otherwise secured to the satisfaction of the Reserve Bank, in unusual and exigent circumstances”, and provided the IPC cannot secure adequate credit elsewhere or is in a class for which this determination has been made.

Notes: All advances and the financial instruments used as collateral in all discounts except section 13(discounts are subject to maturity limitations. Section 13(14) authorizes discounts and advances to branches and agencies of foreign branches, subject to limitations.

*Section 10A provides for advances to groups of member banks.

* * Advances to undercapitalized and critically undercapitalized institutions are subject to limitations listed in section 10B.

* * * Must be endorsed by a depository institution.

* * * * Depository institutions are corporations and thus qualify for lending authorized for IPCs.

60

Even though the Federal Reserve can extend credit to depositories through advances secured by a wide array of instruments, there may be limitations regarding the extent to which the Federal Reserve can take onto its balance sheet the credit risk of a private-sector security pledged as collateral{whether the security is pledged as part of an advance or a discount. With an advance, the loan is extended on the basis of a promissory note issued by the depository. During the course of the advance, should the ability of the depository to repay the advance come under question (for example, because the collateral is in default) the Federal Reserve would look to the depository first for repayment: The credit risk of the collateral therefore remains with the depository.79 In a discount, the depository does not issue its own note to the Federal Reserve, but the depository must endorse the security that is discounted (as indicated by the triple asterisks in table 7.1). Again, the credit risk of the underlying collateral stays with the depository institution, and the only risk the Federal Reserve takes onto its balance sheet is the risk that the depository will default.80

79In a similar vein, the Bank of Japan recently has undertaken repurchase agreements in commercial paper but has acted to protect its balance sheet from the credit risk of the issuer of the commercial paper:

The Bank recommends commercial paper (CP) operations (purchase of CP with resale agreements) in order to ensure smooth market operations.

CP will be purchased from financial institutions, securities companies, and tanshi companies (money market dealers) which hold accounts with the Bank. The CP is to be endorsed by the seller, and to have a maturity of 3 months or less from the day of the Bank’s purchase. Purchase is to be made under competitive bidding, and the period of the purchase is to be 3 months or less. (See Quarterly Bulletin (1996), page 100.)

In September of 1998, the Bank of Japan held, through repurchase agreements, about 35 percent of the outstanding stock of commercial paper in Japan. See Table VII in Economic Statistics Monthly

(See various dates).

80Discounts under sections 13(2), 13(4) or 13A for a bank require a \waiver of demand, notice and protest by such bank as to its own endorsement exclusively”, which is discussed by Hackley (1973)

(pp. 22). The effect of this waiver is to make the endorsing bank primarily liable because the Reserve Bank would not have to demand payment by the issuer of the discounted paper before proceeding against the bank. To further limit its credit-risk exposure, the Federal Reserve presumably would also take a \haircut” on the discount by extending funds that are significantly less than the value of the discounted instrument. Additionally, the Federal Deposit Insurance Corporation Improvement

61

To the extent the credit risk of the collateral remains with the depository, lending to depositories may do very little to lower the credit-risk premiums charged by depositories in making new loans to private-sector borrowers. Credit risk premiums could be a major factor holding down credit expansion and economic recovery should nominal rates on Treasury bills be at or near zero and should the economy be weak.

In private-sector markets, credit risk can be managed through the use of credit- risk options. And, in some circumstances, the Federal Reserve’s incidental powers clause is consistent with the Federal Reserve using options.81 However, the view that the Federal Reserve could not accept the credit risk of the collateral used in discount window loans may leave little scope for the Federal Reserve to write credit-risk options in order to take that credit risk of the balance sheets of depositories and onto its balance sheet.

But even if Federal Reserve loans to depositories leave credit-risk premiums unchanged, such loans may provide some liquidity for the financial instruments used as collateral helping to lowering private-sector interest rates by reducing implicit liquidity premiums.

7.2 Lending to Individuals, Partnerships, and Corporations

Although the Federal Reserve currently does not make loans to individuals, partnerships, and corporations (IPCs), the Federal Reserve has the authorization to bypass depositories and make such loans under sections 13(3) and 13(13) of the Federal Reserve Act- as shown in table 7.1. However, lending under these authorities is subject to very stringent criteria in law and regulation, and such lending has not taken place since the Great Depression. For example, advances, under section 13(13), are limited

Act of 1991 (FDICIA), through its \prompt corrective action” provisions has imposed restrictions on depository institutions in weak capital condition. Among those restrictions are limitations on access to the Federal Reserve’s discount window.

81See footnote 46 for a discussion of the Federal Reserve’s recent use of options, and see Section 4 of Small and Clouse (2000) for a discussion of the Federal Reserve’s authority to engage in options.

62

to those “secured by direct obligations of the United States or by any obligation which is a direct obligation of, or fully guaranteed as to principal and interest by, an agency of the United States.”

Because IPCs with such collateral could easily sell it in the open market, section 13(13) advances may not have much effect(unless done at subsidized rates) in stimulating aggregate demand.

In contrast, private-sector instruments may lack the liquidity of Treasury debt and, therefore, Federal Reserve loans that use them as collateral may provide liquidity and help stimulate the economy. Also, in a \credit crunch”, such direct loans would circumvent depository institutions and the \non-price” terms of credit imposed by them. Hence, we shall focus on section 13(3) discounts of:

“notes, drafts, and bills of exchange when such notes, drafts, and bills of exchange are endorsed or otherwise secured to the satisfaction of the Federal Reserve bank: … ”

Because notes, drafts, and bills of exchange include most forms of written credit instruments, section 13(3) provides virtually no restrictions on the form a credit instrument must take in order to be eligible for discount.82 And by merely requiring that the discount be \secured to the satisfaction of the Federal Reserve bank …”, there is no restriction on the use of funds (such as for \real bills” purposes) for which the discounted security was originally issued.

However, in making section 13(3) loans directly to IPCs, the Federal Reserve must impose standards that are much more stringent in comparison to those used in lending to a depository. Such lending to IPCs is authorized only in “unusual and exigent circumstances.” In particular, the statute requires that a loan can be extended only to IPCs for which credit is not available from other banking institutions.83 Activation

82The distinctions between notes, drafts, and bills of exchange are discussed in detail in Small and Clouse (2000).

83The Federal Reserve’s Regulation A (Section 201.3(d): Emergency credit for others) species that advances to IPCs would be contemplated only in situations in which failure to advance credit would adversely affect the economy.

63

of this authority requires the affirmative vote of five of the seven governors of the Federal Reserve Board.

Section 13(3) further requires that the collateral be “endorsed or otherwise secured to the satisfaction of the Federal Reserve bank …” As interpreted by Hackley (1973):

… it seems clear that it was the intent of Congress that loans should be made only to credit-worthy borrowers; in other words, the Reserve Bank should be satisfied that a loan made under this authority would be repaid in due course, either by the borrower or by resort to security or the endorsement of a third party.84

If binding, this restriction could seriously curtail the effectiveness of such loans in stimulating aggregate demand in an environment of elevated credit risk and risk aversion.

But even if the Federal Reserve were able to accept private-sector credit risk onto its balance sheet, any social benefits to the Federal Reserve lending directly to the private sector would need to be balanced against the potentially serious drawbacks associated with placing the Federal Reserve squarely in the process allocating credit within the private sector. The information available to the Federal Reserve about nonbank credit would in many cases be inadequate to reliably assess credit risks{ and there is little reason to believe the Federal Reserve could assess credit risks more accurately than do private intermediaries. Problems with adverse-selection could lead to the Federal Reserve lending to precisely those credit risks that it most severely underestimates. After the credit is extended, the Federal Reserve may not be well situated to monitor the ongoing activities of the recipients of the funds to ensure the activities are consistent with the terms of the contract. Some of these problems might be addressed through the Federal Reserve using credit-ratings from private sector firms.

Moreover, such programs could develop important political constituencies that might make the programs difficult to dismantle once the immediate aim of policy|

84Hackley (1973), page 129.

64

namely providing a short-run economic stimulus- had been achieved.

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Re: new fed lending facility

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(an interoffice email)

> – any chance they would take discount window rate down intra-meeting (or before year end)

seems they don’t have to with this new ‘facility.’

> – have u evaluated the “loan auction” story?

Seems a lot like ‘standard’ repo apart from accepting pretty much anything as collateral from member banks in good standing. This should allow any member bank to fund itself a the ‘stop’ of the auctions, and I’m guessing that stop will be maybe 25 over funds, just to have some semblence of a ‘penalty rate’ though with no ‘stigma.’

Non member banks will still need to borrow from member banks, most likely, and so to the extent they are in the libor basket the libor settings could stay higher than otherwise. Not sure how all that will settle out.

But member banks using the Fed as ‘broker of last resort’ means borrowing and lending with the Fed will keep the names of other banks off their books over year end, and may make room for member bank/non member bank lending. Hard to say, but prospects look pretty good for this to clear up the year end log jam. Also, the ECB could do same with a $ facility which would also help.

Keep me posted if you hear anything, thanks.

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More detail on the liquidity facility

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looks a lot like the recommendations Karim emailed to them:

An article in the Financial Times:

Fed officials have dusted down this proposal and adapted it to address the current credit market crisis.

Vincent Reinhart, a fellow at the American Enterprise Institute and former chief monetary economist at the Fed, says this kind of auction facility would allow the Fed to provide funds directly to a much larger group of banks than the limited number of primary dealers who participate in open market operations, against a wide range of collateral, without the stigma of the discount window.

“I think it would be very positive,” he says. Banks in need of liquidity could acquire funds relatively anonymously, while the large number of participants with direct access to Fed money would encourage arbitrage to exploit the gap between cheap Fed money and high interbank rates.

Moreover, the Fed could auction funds at whatever term it wanted to in order to target liquidity at particular term markets – for instance, the market for one-month loans. It would have the option of either auctioning a fixed amount of funds, or offering to supply whatever funds were needed at a target rate.

The intended interest rate spread over the Fed funds rate is not known. If the Fed decided to auction loans at or only slightly above the Federal funds rate, it would risk subsidising weaker banks, which normally pay a premium to borrow in the interbank market.

However, Mr Reinhart says this could be dealt with by varying the amount of collateral required in return for loans based on the creditworthiness of the bank seeking funds.

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Wray discussion

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(an email with Randall Wray) 

On Dec 11, 2007 10:49 PM, Wray, Randall <WrayR@umkc.edu> wrote:
> Warren: very respectfully, I suggest you might reconsider both your model of the fed’s reaction function as well as the likely course of the “real” economy.
>
> Whatever the fed might have said about “fighting inflation” back last summer is not relevant to near- and medium-term policy. The fed is scared nearly out of its mind about financial mkts and spill-over to the “real economy”. Further, it realizes all inflation pressures are in sectors over which it has no control, and that are just “relative value” stories. Yes, there can be some feed thru effects to nominal values, but the Fed can’t do anything about it. Inflation will not enter the Fed’s decision making in the near and medium term. Yes, they will continue to pay lip-service to it, since their whole strategy of inflation management relies on expectations. But they are far more concerned with asset prices, financial markets, and, less importantly, economic performance.

Already agreed.  As Karim says it, they want to put the liquidity issue to be first, then worry about inflation.
I’m guessing that the ‘new’ liquidity facility they just announced that will be used to set rates over year end for member banks with a greatly expanded list of acceptable collateral may do the trick.

If so, much of the ‘fear’ is gone, and it’s back to the more traditional and ‘comfortable’ inflation vs the economy, which is a
whole different ball game.

>
> The “markets” are also scared out of their minds. Maybe they are all completely wrong, and you are the lone voice of reason. Maybe nothing is going to spill-over into the real sector. But it is worth considering that MAYBE they are correct.

I do give that some weight.  Maybe 25%?  And with govt, pensioners, and indirect govt sectors not going to slow down, the rest has to slow down quite a bit just to get to 0 real growth.  In fact, I see the biggest chance of negative growth coming with ok nominal growth but a high deflator due to statistical variation.  Nominal shows no signs of slowing, and it is a monetary economy.

 My continuing point, however, is that it’s not happening yet, nor is anything I’m seeing that is yet showing actual weakness, apart from so far anecdotal statements about retail sales, and the .2 nominal personal spending number last reported. I have also seen nothing but low gdp forecasts getting revised up continuously.  Maybe that changes.  However, if demand does weaken, I’m not sure it would be due to the financial losses as I still see no ‘channel’ from that to the real economy, apart from  CNBC scaring people into not spending, and that is not a trivial effect!  But so far there doesn’t seem to anything reducing personal income, and borrowing power seems reasonable if the desire is there for (now cheaper) homes, cars, computers, etc. with a non trivial amount coming from export earnings, which seem to be going parabolic.
> In any case, it will probably help you to predict what mkts are doing if you consider that they REALLY believe we are headed for a hard crash, and that this is not just media manipulation. They could be completely wrong. But at least we can predict their behavior.

I hear you, and in fact that has been my explanation of why they 50 in Sept, and then 25 in Oct- blind fear of the unknown/crash landing. But how does that explain yesterdays outcome?  It was at the very low end of expectations.  They even were stingy on the discount rate spread, which costs them nothing in terms of inflation.  All you can say is they were trying to avoid moral hazard risk, which indicates a lot less fear of hard landing than previously, along with reasonably
harsh language on inflation to ‘explain’ to the markets the stinginess of their actions?

>
> I do agree with you that there will be a reversal tomorrow, and after every disappointment at the Fed’s actions. But that is froth. Mkts have to take profits where they can find them–and after 300 points down, the mkt looks cheap. Yes, mortgages are being made. Yes, investment banks will buy-out insurers (to minimize losses–even if the insurers eventually go bankrupt), and so on. You get profits where you can, or you lose all of your business.

Right, a basic driver of capitalism.  The old ‘fear vs greed’ pendulum.

>But massive losses and write-downs will continue. Maybe they are
wrong to do it; maybe it is just paper shuffling; but it is worth
considering that after a few trillion dollars of losses, there could
be a real effect on the economy.

Sure, but you know as well as anyone the real economy is a function of agg demand.  And there’s been no credible channel discussed of how agg demand gets reduced that’s showing up anywhere in the data.  To the contrary, the non resident sector has suddenly become a source of demand for US output that’s already more than made up for the outsized
and sudden drop from the housing sector, as the bid for housing from sub prime borrowers vanished.  That’s an example of a major demand channel vanishing that could have taken the economy down, but was coincidentally rescued by the foreign sector.  The present value gains from the new export demands are roughly offsetting the pv losses from the sub prime bid vanishing.  Hence, equity markets are up about 10% for the year.

The siv’s, the spv’s the junior tranches, and the super senior tranches all have massive negative present values. Yes, if we can ride it out, in 10 years they could all come back. As keynes said, life is too short.

We don’t have to ride out anything if our purchasing power is unchanged at the macro level, and we can sustain demand for our output.

>
> Even if all we are interested in is to predict what the fed and mkts are going to do, it is worth considering that the Fed BELIEVES it is fighting a Fisher-type 1930s debt deflation that will bring down the whole economy, and that most in the mkts also believe that is a plausible outcome.

Agreed!

>They might all be crazy. But they can be self-fulfilling.

yes, as above.

>So far as I know, EVERY former fed official who is now free to speak
is projecting more rate cuts and recession and maybe worse. That
includes mister inflation hawk Larry Meyer (for whom I TA-ed). The
notion that inflation is a problem just is not going to get traction.
maybe not.  but they all blow with the wind- especially the media- and after this weeks inflation numbers we’ll have a better idea.

>
> I could be wrong, but I’m not paid to be right! I view it all as a bemused spectator. However, millions of Americans WILL lose their homes. Maybe they shouldn’t have them. I do not know, but I do lean toward the view that they should and that policy ought to aim for protecting home ownership. In any case, I find it very hard to believe that will have no effect on the economy.

We’ve already had the effect, as above, and it’s been offset by export earnings, at least so far.  Maybe ‘millions’ will lose ownership, but they won’t be unemployed and homeless.  They will rent, or get owner financing, or get bailouts from relatives, etc.  Mtg rates are down from last summer, affordability is up, and employment is relatively high as well.

The only thing to fear is CNBC itself.

Thanks!!!

Warren

> L. Randall Wray
> Research Director
> Center for Full Employment and Price Stability
> 211 Haag Hall, Department of Economics
> 5120 Rockhill Road
> Kansas City, MO 64110-2499
> and
> Senior Scholar
> Levy Economics Institute
> Blithewood
> Bard College
> Annandale-on-Hudson, NY 12504

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Fed set to revamp liquidity support

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Thanks – sounds very similar to what we recommended to them – Fed acting as ‘broker of last resort’ between member banks in good standing. This will get the fed member banks over year end where the liquidity issues are currently concentrated.

Not sure why they didn’t announce this at the meeting to reduce vol after the statement.

http://www.ft.com/cms/s/0/6bcfd8ee-a80d-11dc-9485-0000779fd2ac.html?nclick_check=1

The Federal Reserve is set to overhaul the way it provides liquidity support to financial markets, following a negative reaction to Tuesday’s interest rate cut.

US stocks fell sharply after the central bank cut rates by only 25 basis points to 4.25 per cent and failed to offer a clear signal of more to come.

The overhaul, which could be announced as early as Wednesday, is likely to take the shape of a new liquidity facility that will auction loans to banks. This would allow the Fed to provide liquidity directly to a large number of financial institutions against a wide range of collateral without the stigma of its existing discount window loans.

The idea is that this would ease severe strains in the market for interbank loans, and help restore more normal conditions in credit markets generally.

However, it is unclear whether the new initiative will win over investors disappointed by Tuesday’s announcement. Many had hoped for a 50bp cut in the main interest rate, or at least a 50bp reduction in the discount rate, and a stronger indication of further cuts in the pipeline.

Dominic Konstam, head of interest rate strategy at Credit Suisse, said: “The Fed disappointed the market in lots of ways.”

The S&P 500 closed down 2.5 per cent at 1,477.65, after being up 0.4 per cent before the decision was released. The yield on the two-year Treasury note was at 2.92 per cent, down from 3.14 per cent.

The sell-off spread to Asia and Europe on Wednesday. Shares in Hong Kong led the retreat, with the Hang Seng index falling 705.78 points or 2.4 per cent to 28,521.06, while the Nikkei 225 slumped 112.46 points or 0.7 per cent to 15,932.26.

In Europe, banks and companies with heavy US exposure led fallers. The FTSE 100 was down 61.6 points or nearly 1 per cent, while the Dax 30 shed 48.51 points or 0.6 per cent to 7,960.91. The CAC 40 in Paris fell 64.96 or 1.1 per cent to 5,659.80.

The Fed said the deterioration in financial market conditions had “increased the uncertainty surrounding the outlook for economic growth and inflation”.

But while it dropped its assessment that the risks to growth and inflation are “roughly balanced”, the Fed did not say that it now thinks the risks to growth outweigh the risks to inflation.

It offered no assessment of the balance of risks, saying it would act “as needed” to foster price stability and sustainable economic growth. This formula in effect means the Fed is keeping its options open.

Investors could infer a willingness to consider future rate cuts, but the signal was weaker than many had expected. This reflects the fact that the Fed remains more concerned about the risks to inflation than most investors.

The Fed said “incoming information suggests that economic growth is slowing” reflecting an “intensification of the housing correction” and “some softening in business and consumer spending.” It acknowledged that “strains in financial markets have increased in recent weeks”.

However, the US central bank made almost no changes at all to its language on inflation, reiterating that “energy and commodity prices, among other factors, may put upward pressure on inflation”.

Eric Rosengren, a committee member and president of the Boston Fed, dissented in favour of a 50bp cut. At the last meeting, Tom Hoenig, president of the Kansas City Fed, dissented in favour of no cut.

Money market traders had earlier priced in a decline in Libor when it sets on Wednesday. Later, those expectations reversed and one-month Libor is seen at 5.21 per cent on Wednesday, up from an estimate of 4.96 per cent and above Tuesday’s setting of 5.20 per cent.

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Ip: intermeeting ease/action

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(an interoffice email) 

Thanks, and good call!
>
>
>
> Many I spoke to post-fomc talked about an intermeeting ease on the discount
> rate.
>
> Also, that the Fed would use their mouthpieces (Ip,e.g.) to get a message
> out tomorrow if today’s reaction went poorly.
>
> So here we have it, Ip story tonight on potential discount rate cut within
> ‘days’
>
>

Fed Cuts Rates, Seeks New Ways To Thaw Credit
By GREG IP

December 12, 2007

WASHINGTON — With a deepening credit crunch threatening to drag the stalled U.S. economy into recession, the Federal Reserve cut interest rates for the third time since August, and left the door open to further cuts.

But yesterday’s cut, at the low end of Wall Street’s hopes, disappointed investors, who hoped the Fed would do more to thaw frozen credit markets. The Dow Jones Industrial Average fell sharply, undoing about a third of the run-up in stocks triggered in late November when top Fed officials first publicly signaled that another rate cut was likely. The blue-chip average ended the day at 13432.77, down 294.26 points, or 2.1%.

The Fed lowered its target for the federal-funds rate, charged on overnight loans between banks, by a quarter percentage point to 4.25%. It also cut the discount rate, at which it lends directly to banks, by the same amount, to 4.75%.

Fed officials, however, continue to consider ways of using various tools – including the discount rate — to combat banks’ unwillingness to lend even to each other, which they view as a threat to economic growth. The central bank could take action within days.

A variety of steps, widely discussed in the markets, are likely to be on the table, including another cut in the discount rate, longer-term loans to money-market dealers, easier collateral rules for loans from the Fed, and other complex steps last taken in 1999 to alleviate funding pressures ahead of the year 2000, when many feared a “Y2K” computer bug would disrupt markets and create economic havoc.

Changes in the discount rate can be made by the Fed board in Washington without the approval of the entire 17-member policy-making Federal Open Market Committee, which sets the federal-funds rate target.

Some on Wall Street yesterday criticized the Fed’s actions so far as inadequate. “From talking to clients and traders, there is in their view no question the Fed has fallen way behind the curve,” said David Greenlaw, economist at Morgan Stanley. “There’s a growing sense the Fed doesn’t get it,”

Markets expect a weakening economy will force the Fed to cut rates more, Mr. Greenlaw said. Futures markets expect another cut in January and a federal-funds rate of 3.25% by next fall.

In its statement yesterday, the Fed said that its quarter-point rate cut, which pushed the federal-funds rate a full percentage point below where it stood in early August, “should help promote moderate growth over time.”

The central bank didn’t, as it did in October, say the risks of weaker growth and of higher inflation were roughly balanced. That message was a signal that the Fed didn’t expect to cut rates again.

Instead, the Fed said yesterday it will to “continue to assess the effects of financial and other developments on economic prospects and will act as needed.” By avoiding any explicit indication of its next move on rates, the Fed left its options open for its next meeting in late January.

The FOMC’s 10 voting members approved the rate cut 9-1. Federal Reserve Bank of Boston President Eric Rosengren dissented in favor of a sharper, half-point cut. One FOMC member also dissented in October, but in favor of no rate cut. The shift in the dissents, from wanting less rate cutting to wanting more, symbolizes the swing toward pessimism at the Fed.

“Economic growth is slowing, reflecting the intensification of the housing correction and some softening in business and consumer spending,” the Fed said yesterday. “Moreover, strains in financial markets have increased in recent weeks.”

Unlike the previous two rate cuts, yesterday’s wasn’t portrayed as “insurance” against improbable but damaging economic scenarios. That suggests Fed officials view the economy as weaker than they expected as recently as late October.

Corporate executives are also signaling a more downbeat outlook. “I’m not going to put a happy face on this. Consumers are going to be a challenge in 2008,” General Electric Co. Chief Executive Jeffrey Immelt told investors yesterday. But global growth is “as strong as ever,” he added.

When Fed policy makers met in late October, financial markets were in better shape than they had been in August, and the economy had just posted a strong third-quarter performance. They chose to cut rates by a quarter point and concluded that would likely be enough.

But in subsequent weeks, markets reversed course as big losses tied to soured mortgage-related investments cut into the capital of major banks and other financial institutions, limiting their ability to lend. Fed Chairman Ben Bernanke and Vice Chairman Donald Kohn signaled their increased concern in speeches in late November, foreshadowing yesterday’s rate cut.

Even so, investors, who have persistently had a gloomier outlook than the Fed, were disappointed the Fed didn’t cut rates more or signal greater willingness to do so. Bond prices shot up and yields, which move in the opposite direction, fell sharply. The 10-year Treasury note’s yield dropped to 3.97% from 4.1% just before the announcement, while the two-year note’s yield, which is especially sensitive to expectations of Fed action, fell to 2.92% from 3.13%. Yields on corporate bonds rose relative to Treasurys.

Major banks, meanwhile, lowered their prime lending rates, the benchmark for many consumer and business loan rates, to 7.25% from 7.5%.

The Fed has found it especially difficult to discern the economy’s path and thus the right level for rates because the main threat facing the economy is the reluctance of banks and investors to lend to homebuyers, businesses and consumers. That’s harder to measure than the things like profits, inventories, employment and the Fed’s own interest-rate actions that usually drive the business cycle.

“Well, the boys blew it again. You wonder which economy they are looking at and what it is they are thinking about,” said Alfred Kugel, Chicago-based chief investment strategist for investment-management firm Atlantic Trust of Atlanta.

Brian Sack, an economist at Macroeconomic Advisers LLC, said that in 2001 the major shock to the economy was the stock market. “We have a better shot at trying to calibrate those wealth effects, whereas the credit turmoil has many dimensions to it. Frankly it’s hard to assess how much economic restraint you get from those various dimensions.”

In the past month, data on the so-called real economy has been soft but not dramatically so. Macroeconomic Advisers said yesterday it now expects the economy to shrink marginally during the current quarter, then grow at a 1.8% annual rate in the first quarter of 2008.

On the other hand, credit markets have tightened sharply. Since Oct. 31, the yields on securities backed by auto loans has jumped to 6.3% from 5.4%, while yields on securities backed by home-equity loans have jumped to 7.7% from 6.6%, according to J.P. Morgan Chase & Co. Rates on “jumbo” mortgages — those larger than $417,000 — are around 6.9%, up from 6.6%. The London interbank offered rate, the rate banks charge each other for three-month loans in the offshore market — is a whopping full percentage point above the expected federal- funds rate; it is typically less than a tenth of a point higher.

There isn’t yet evidence these higher rates have significantly bit into consumer spending, outside of housing, and the rates could drop after year-end funding pressures ease. But investors generally don’t expect that to happen.

A survey by Macroeconomic Advisers of its clients, mostly hedge funds and other sophisticated investors, found most expect little retracement of the wide spreads between yields on risky debt and Treasury yields by next year and most expect banks to curtail lending. “The possibility of a widespread pullback in credit availability is a significant risk to the outlook,” the firm said.

♥

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Roubini blog

Posted on by

Roubini totally doesn’t get it.

The point of CB intervention is to keep interest rates at their target rates, not to provide funds for lending, as described in previous posts.

This plan will succeed at doing that, best I can tell.

It’s all about price, not quantity.

That’s all a CB can do.

Also, insolvency matters to the real economy only as it reduces aggregate demand.

The largest current risk to aggregate demand in my estimation is the media frightening businesses and consumers from spending.

That’s always a risk to a monetary economy where the government isn’t standing by to net spend when demand sags. When government does that there is little or no risk of negative growth or unemployment as we currently define it.

Nouriel Roubini | Dec 12, 2007

Given the worsening of the global liquidity and credit crunch – with a variety of short term interbank Libor spreads relative to policy rates and relative to government bonds of same maturity being even higher recently than at the peak of the crisis in August – it is no surprise that central banks were really desperate to do something.

The announcement today of coordinated liquidity injections by FED, ECB, BoE, BoC, SNB is however too little too late and it will fail to resolve the liquidity and credit crunch for the same reasons why hundreds of billions of dollars of liquidity injections by these central banks – and some easing of policy rates by Fed, BoC and BoE – has totally and miserably failed to resolve this crunch in the last five months. What was announced today are band-aid palliative that will not address the core causes of this most severe liquidity and credit crunch.

There has some heated debate in recent weeks on whether the liquidity crunch is due to:

  1. short-term year end liquidity needs (the “Turn”);
  1. a more persistent liquidity risk premium;
  1. a rise on counterparty risk and broader perceived credit problems of counterparties; i.e. serious problems of insolvency rather than illiquidity alone.
  1. a more general increase in risk aversion due to severe credit problems and information asymmetries (risk aversion due to uncertainty about the size of the financial losses and uncertainty on who is holding the toxic waste of RMBS, CDOs and other ABS products);
  1. the failure of the monetary transmission mechanism in a financial system where most financial institutions are now non-bank and thus do not have direct access to the central banks’ liquidity or lender of last resort support.

The severe financial crunch is likely due to all of the factors above; but the measures announced today can only partly deal with the first of the two explanations above of the crunch and will do nothing to address the other causes of the crunch. These measures will not be successful for a variety of reasons.

First, you cannot use monetary policy to resolve credit and insolvency problems in the economy; and most of the crunch is due not just to illiquidity but rather to serious credit and solvency problems of many economic agents (households, mortgage borrowers, subprime, near prime and prime mortgage lenders, homebuilders, highly leveraged and distressed financial institutions, weak corporate sector firms).

Second, monetary injections cannot resolve the information asymmetries and generalized uncertainty of a financial system where financial globalization and securitization have led to lack of transparency and greater opacity of financial markets; these asymmetric information problems that generate lack of trust and confidence and significant counterparty risk cannot be resolved with monetary policy.

Third, the US is at this point headed towards a recession regardless of what the Fed does as the build-up of real and financial problems (worst housing recession ever, oil at $90, a severe credit crunch, falling capex spending by the corporate sector, a saving-less and debt burdened consumer buffeted by ten separate negative shocks) in the economy make a recession unavoidable at this point; similarly other economies are also now headed towards a hard landing as the US real and financial mess lead to significant contagion and recoupling.

Thus, to mitigate the effects of an unavoidable US recession and global economic slump the Fed and other central banks should be cutting rates much more aggressively. The 25bps cut by the Fed yesterday is puny relative to what is needed; 25bps by BoE and BoC does not even start to deal with the increase in nominal and real borrowing rates that the sharp spike in Libor rates (the true cost of short term capital for the private sector) has induced.

And the ECB decision not to cut policy rates – and deluding itself that it may be able to raise them once the alleged “temporary” credit crunch is gone – is dangerous and ensures a sharp slowdown in a Eurozone where deflating housing bubbles, oil at $90 and a strong Euro are already sharply slowing down growth. Central banks should have announced today a coordinated 50bps reduction in their policy rates as a way to signal that they are serious about avoiding a global hard landing. Instead the Fed yesterday gave a paltry 25bps with a neutral bias rather than the necessary easing bias.

Fourth, the actions by the Fed today provide more liquidity to a greater variety of institutions but, as the Fed announced, these institutions are only “depository” institutions, i.e. only banks. The severe liquidity and credit problems affect today a financial market dominated by non-bank that do not have direct access to the liquidity support of the Fed; these include: broker dealers and investment banks that do not have a commercial bank arm; money market funds; hedge funds; mortgage lenders that do not take deposit; SIVs, conduits and other off-balance sheet special purpose vehicles; states and local governments funds (Florida, Orange County, etc.).

All these non-bank institutions do not have direct access to the Fed and other central banks liquidity support and they are now at risk of a liquidity run as their liabilities are short term while many of their assets are longer term and illiquid; so the risk of something equivalent to a bank run for non-bank financial institutions is now rising. And there is no chance that depository institutions will re-lend to these to these non-banks the funds borrowed by central banks as these banks have severe liquidity problems themselves and they do not trust their non-bank counterparties. So now monetary policy is totally impotent with dealing with the liquidity problems and the risks of runs on liquid liabilities of a large fraction of the financial system (in a world where these non-bank financial institutions play a larger role in financial markets than non-banks).

And let us be clear: the Federal Reserve Act striclty forbids the Fed from lending to non-depository institutions apart from very emergency situations that would require a complex and cumbersome approval process and the provision of high quality collateral. And the Fed has never – in its history – used this procedure and lent money to non-depository institutions.

Fifth, as discussed before on this blog, this is the first real crisis of financial globalization and securitization; it will take years of major policy, regulatory and supervisors reform to clean up this disaster and create a sounder global financial system; monetary policy cannot resolve years of reckless behavior by regulators and supervisors that were asleep at the wheel while the credit excesses of the last few years were taking place. Now the US hard landing and global sharp slowdown is unavoidable and monetary policy – if aggressive enough with much greater and rapid reduction in policy rates – may only be able to affect how long and protracted this hard landing will be.

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Re: credit recap

Posted on by

(an interoffice email)

>
>
>
> Mkt did not like the Fed move today- IG9 went from 70 out to 78.75 after the
> news. CMBS cash (which had a roaring spread tightening in the morning of
> about 15bp) gave all but 6bp of it back. There was a rumor this AM that
> JPM is taking a look at Wamu, but nothing official materialized yet.

Thanks, watching to see if the tightening resumes after this afternoon’s ‘reduction of risk’ reaction to the fed report.

>
>
> General Credit News
>
> The US Federal Reserve cut the Fed Funds Rate by ¼ point and the discount
> rate by ¼ point. The market sold off due to discount rate cut being less
> than expected (people expecting a ¾ point cut). Also, the fact the Fed
> maintained concerns about inflation worried people.

Yes, the media had convinced everyone they didn’t and shouldn’t care about inflation.

>
>
>
> The CEO of the Dubai owned investment firm Istithmar PJSC said that US
> financial and real estate companies are at “attractive valuations” after
> their shares fell on the subprime mortgage crisis. The CEO said, “We feel
> there’s been an overreaction and the market has not yet separated the wheat
> from the chaff.”

Agreed!

>
>
> German investor confidence dropped more than economist forecast in December,
> reaching their lowest level in almost 15 years as rising credit costs dimmed
> the outlook for economic growth.

They must be watching CNBC, too!

>
>
>
> Homebuilder shares fell the most ever on speculation that the Fed’s interest
> rate cut may not be enough to increase demand for new homes or prevent a
> recession. S&P’s measure of 15 homebuilders dropped 9.7% today after the
> Fed cut rates by ¼ point.

Overreaction is my best guess.

>
>
>
> Citigroup Inc. (C): Board appointed Vikram Pandit CEO.
>
>
>
> Fannie Mae (FNM): CEO said the US mortgage and housing markets are unlikely
> to recover until at least 2010.

May not go through old highs until then, but should be bottoming somewhere around current levels of activity.

♥

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UST ASW update

Posted on by

(an interoffice email)

>
>
> 16bp day for 2yr spreads today:
>
>
>
> The market went into the fed announcement expecting perfection
>
> 25-50bp cut and 50bps on the discount window.
>
>
>
> Spreads were 6 lower on the day in the 2yr sprds and 3 lower in tens before
> the Fed.
>
> Needless to say the market was disappointed…
>
> Spreads moved back to the wides in the front end
>
> and now are repricing an expectation of extended financial market /
> financing turmoil

Hi,

Looked to me like the post fed moves were unwinds of all sorts, and didn’t fit any other theme, so I’ll be watching for reversals after things settle down tomorrow am.

Interesting that the markets were shocked that the Fed cared about inflation. I read the speeches as saying they do care a lot, but the media glossed over those parts and didn’t even report those references.

And also interesting that interest rates went lower in response to the Fed caring about inflation.

Also, the strong yen vs the pound and euro, for example, was the reaction to ‘stress’ type of move we saw beginning in August.

While the FOMC didn’t do much to alleviate stress per se, they didn’t actually *do* anything to make it worse, either, and there were signs it was running its course, with the year end issue the remaining
hurdle. I’ll be looking for signs the NY Fed is working on that tomorrow and watching to see if 3 mo libor comes back down over the next few days.

The CPI and PPI are expected to be off the charts Thursday and Friday, and the media could start harping on inflation, blame the Fed for high oil prices, questioning whether a half point in the funds rate over the last few months was worth a $20 increase in the price of crude, and continue pushing that theme if crude goes up as I expect it will, as Saudis continue to (irregularly to hide what they are doing) hike posted prices and let the quantity they pump vary. (and Russia
probably doing same as well.) At 120 crude, retail gasoline should be pushing $4 and food up as well via the biofuel connection, and the media attack on the Fed for letting the inflation cat get out of the bag can elevate expectations rapidly, with tips breakevens and Michigan expectations numbers elevating rapidly.

So far, higher crude means lower yields, as it is anticipated the economy will weaken and the Fed doesn’t care about inflation. If/when that changes- as evidenced by higher crude causing higher interest rates even with risk to gdp- tensions and stresses move up several notches, as anyone working through the 70’s and 80’s should recall.

Given the coming inflation numbers, a segment of the mainstream will start to point out that the ‘correct’ fed funds rate is about 7% with inflation at about 4. To them a neutral real rate would put the ff rate at 6, so it will take 7 to be restrictive. They will argue headline cpi is the rate to use, as food and energy are trending and sustaining the higher levels, along with import and export prices rising at more than 5% rates, and therefore this group will give greater weight to core moving up to headline as happened in the 70’s when crude trended upwards for an extended period of time. And should crude continue to move up, this initially small group of mainstream economists will grow, and CNBC will help promote this ‘scare story’ as it attracts more and more viewers.

Hoping things don’t go that way but concerned they will. Looking forward to reactions to the data later this week and what commodity prices do from here.

♥

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