The Fed Prepares the Bailout Bucket

The big news on Wall Street last Friday was that the Fed cut the discount rate.

From Bloomberg:

The Federal Reserve unexpectedly cut its discount rate and said it's prepared to take further action to "mitigate'' damage to the economy from the rout in global credit markets.

The central bank reduced the rate at which it makes direct loans to banks by 0.5 percentage point to 5.75 percent. Policy makers kept their benchmark federal funds rate target unchanged at 5.25 percent. It's the first reduction in borrowing costs between scheduled meetings of the Federal Open Market Committee since 2001 and Ben S. Bernanke's first as Fed chairman.

The Fed also noted:

The Federal Reserve will continue to accept a broad range of collateral for discount window loans, including home mortgages and related assets.

[...]

These changes are designed to provide depositories with greater assurance about the cost and availability of funding.

This statement was in response to the fact that many banks are increasingly unwilling to let hedge funds and other institutional investors use credit portfolios as collateral for loans. However, it doesn’t address the fact that many banks are employing common sense by being wary of loans backed by debt securities, after scores of institutional investors lost billions due to improperly valuing debt securities and then borrowing against them.

The rate cut led to a wild ride for many beleaguered financial stocks, with many rocketing up in early morning training, prior to settling down by close, but still up for the day.

click to enlarge

It appears, for now, that Wall St. may indeed get the Federal Reserve bailout it was praying for with the first round occurring today. If the Fed’s goal was to restore investor confidence, the early returns show that we’re headed in that direction (for now at least). Only time will tell if we’re able to turn the momentum from Thursday afternoon and Friday morning into a long-term rally.

My thoughts on the rate cut are as follows:

1) The biggest beneficiaries are going to be companies like Countrywide (CFC) and Thornburgh Mortgage (TMA); profitable on the bubble companies that were in danger of becoming victims of the credit crunch. For Countrywide in particular, the rate cut should give them the breathing room necessary to make the transition to funding their loans via Countrywide FSB and/or originating loans that can be sold to the Mortgage GSEs.

2) It doesn’t change much and in many ways, it’s just a placebo. Lower rates can’t truly raise investor confidence when investors worldwide are still losing money due to mortgage debt securities, loan defaults, and accelerating losses. In addition, hedge funds and other institutional investors are still over-leveraged on mortgage debt securities, etc.

3) Once the excitement dies down and bad news related to mortgage lenders, retail bank loan losses, and credit markets continues to pour in, we could see things reverse drastically.

4) We’re on a potentially dangerous sliding slope right now, because if the Fed decides to “fix” the credit crisis via multiple rate cuts. It’s basically sending the message that the Fed is going do what it can to create the level of confidence required to enable the credit markets to function as if it was 2004. The long-term consequences of this action would be rather disastrous as low rate cuts coupled with bad business practices are what got us into this situation.

The rate cut is here, but it still doesn’t change the real question “What is going to be done about the assumptions, lending standards, and business practices that created this mess in the first place?” There is a lot of talk and thought going into short-term solutions, but not enough into long-term solutions that would prevent a credit crunch from happening in the first place.

Comments

[Malkiel:]

Agreed, it was a placebo, and I find it worrisome that so many experienced business players aren't making the right calls on what the real medicine should be.

The place where everyone is on the same page is about tightening retail mortgage underwriting standards, so the remaining problem areas are foreclosures and commercial paper. I don't have any suggestions on the latter, but it isn't going to fly on foreclosures to take a simple-minded market ideologue's "let 'em fail" approach. Families that lose their homes become our collective burden in messy and unpredictable ways, such as crime or social problems. It's pretty obvious that the political sector will do something to head that off, so business should work with them to perform a triage that allows the viable ARMS holders to move into some other mortgages which they can carry. The lending industry and Congress need to iron out their respective problems in order to re-establish mortgage products needed for rollovers. Freddie/Fannie need to hurry up with their internal auditing so that they can expand their operations and the industry needs to re-establish confidence so that investors will be willing to pick up products like low- and no-down payment mortgages which some rollovers will need. The goal is to bail out the viable mortgage holders, not the companies, whose relief will instead consist of reforming the underlying product...

2007 Aug 20 04:34 PM

[Sr. Pessimist:]

That's a good point. Let them fail. Just because there's a lot on board doesn't mean they're worth saving. Severance of capital from equity is the driving force of the big failures. To do good for the economy, invest where equity buoys capital, as opposed to inflating the currency supply to make up for capital-equity severance schemes.

2007 Aug 20 09:07 PM