Was the Discount Rate Cut Mostly Symbolic?

There's been a lot of talk about the significance of the Fed's cut in the discount rate and whether it was more than a symbolic gesture.

The WSJ notes one way in which it may have been more than symbolic. A big problem for those who held mortgage-backed securities was that in many cases they were unable to find buyers, hence these assets could be used in trade for needed liquidity. But if the Fed is willing to accept these securities as collateral on discount loans, then, with banks acting as intermediaries between those holding the assets and the discount window, the liquidity problem is eased:

How a panicky day led the Fed to act, WSJ: Over the past few weeks, Wall Street executives peppered Fed officials in New York and Washington with suggestions for easing the logjam in credit markets. One idea was for the Fed to widen the type of assets it accepts in its "open-market operations," when it pumps cash into the economy by buying U.S. government bonds... Some thought the Fed should buy lower-quality mortgages. ...

For several days, Mr. Bernanke pondered options with his confidants. ... The officials were looking for a maneuver dramatic enough to shore up confidence, while avoiding a cut in the Fed's main interest rate, the federal-funds rate. Mr. Bernanke was still not convinced the economy needed a cut, and some Fed officials feared it might encourage more of the sloppy lending that led to the crisis.

They began to look more closely at the discount window. Banks remain well-capitalized and profitable. But they appeared reluctant to provide credit to companies, issuers of commercial paper and even each other, perhaps out of uncertainty over the safety of their customers or their collateral.

Eventually, Fed officials agreed to reduce the rate charged on loans from the discount window (to 5.75% from 6.25%) and try to reduce the usual stigma associated with such loans. By making these direct loans to banks more attractive, the Fed hoped to reassure banks that they could borrow if they needed to -- without the usual penalty to their bottom line or to their reputation...

Particularly at times of stress, what the Fed says can be almost as powerful a weapon as what the Fed does. So Mr. Geithner, whose job makes him the traditional liaison to Wall Street, turned to a convenient forum, the Clearing House Payments Co., which is owned by a group of banks and operates much of the plumbing of the nation's financial system. ...Mr. Geithner sought a 15-minute telephone conference call.

On the call were commercial bankers who work with Clearing House as well as several top investment bankers...

Joined by Mr. Kohn, but not Mr. Bernanke, Mr. Geithner told banks about the discount-rate cut and said they could wait up to 30 days, instead of just a day, to pay back their discount-window loans. "We will consider appropriate use of the discount window...a sign of strength," said Mr. Geithner, according to a participant. ...

Another banker participating in the call said of the Fed, "What they came up with is pretty ingenious." Investment banks or hedge funds that hold mortgage-backed securities can't borrow from the Fed directly, but they can bring those securities to banks. In turn, the banks can offer the paper as collateral to the Fed for a 30-day loan.

The Fed "really wanted to drive home the point that if [bankers] were complaining about not being able to borrow money against liquid, high-quality securities -- mortgages -- we have no more basis for complaint. We were all given a clear message," says this banker. ...

Should the Fed should be intervening in mortgage markets at all? One justification for intervening is that there is a threat to the macroeconomy generally. When the cost of intervening (e.g. encouraging bad economic behavior in the future) is less than the cost of doing nothing (and potentially allowing catastrophic macroeconomic problems and costs to individuals who had nothing to do with the decisions that caused the problems), then intervention is justified.

I am still undecided as to how much of a threat problems in these particular markets pose for the macroeconomy generally, but since that uncertainty includes a significant chance that there would be big problems if there had been no intervention, it was prudent of the Fed to react. In any case, it may be time for the Fed to rethink what the term "bank" encompasses in today's financial markets, and to put institutions and regulations in place that can respond appropriately to problems that threaten the overall economy.

Update: I see James Surowiecki is thinking along the similar lines,:

When the health of the U.S. economy is under serious threat, the Fed should act. But in this case it’s far from clear that the turmoil was an actual menace to the underlying economy... Bailing out hedge-fund managers was great for Wall Street, but it may not have been such a good deal for Main Street.

Wall Street so dominates our image of the U.S. economy these days that it’s easy to assume that what’s bad for the Street must be bad for everyone else. But, while it’s true that a complete market meltdown would have disastrous effects on the economy as a whole, market downturns like those of the past few weeks often have only a small effect on businesses and consumers. In part, that’s because much of what happens on Wall Street consists of the shuffling of assets among various well-heeled players, rather than anything that’s fundamental to the smooth functioning of the U.S. economy. ... Similarly, ... stock-market tumbles ... have no concrete impact on most American consumers... And, in the short run, they’re irrelevant to most corporations, too, since few companies actually use the stock market to raise capital. ...

That’s not to say that the economy has suffered no fallout from the subprime collapse. The fall in housing prices, the drying up of new construction, and the sharp rise in foreclosures in many areas are having a serious impact on employment and economic growth. But... Cutting the discount rate is not going to help subprime borrowers get new loans, nor will it get the housing market moving again. What it will do is reassure investors and save some money managers from well-deserved oblivion. It may be that the risk of a full-fledged credit crunch was high enough to make this worth doing. But there is something unseemly about watching the avatars of free-market capitalism rely on the government to pay for their bad bets. And there is something scary about contemplating the even bigger bets they’ll make in the future if they know that the Fed is there to bail them out.

Comments

[bakho]

Anything the Fed does is going to be less effective because fiscal policy is so out of whack. If the government were collecting more %GDP in taxes, the Fed could lower interest rates without being inflationary.

[dd]

So, Mr. Geithner has finally surfaced in the news media; been awaiting his solution and maybe this will work in the short run and settle markets. The underlying problems remain and as long as the news media keeps calling it a "subprime" problem it may yet be contained. Good luck Mr. Geithner.

[op]

"When the cost of intervening ...is
( ---possibly ----)
less than the cost of doing nothing.."

simple but precisely the policy pivot

optimal socialization
of risk
needs to be disentangled
from all this hoo haaa about hazards and perverse inventives

one can look at the deposit insurance...for that matter limited liability corporations
as socializers of risk
obviously
a netework of enlightened and enforced regs
become the necessary complimemtary set of " social goods "

vide the now near 20 years past
S&L scambo-ree

if you want to see topless goods
gone wild

also for those of u
with a bent
for convincing beauties
of the thin air abstractiion variety
flip thru
the arnott stiglitz theorem

[op]

bakko :

"...the Fed could lower interest rates without being inflationary "
the crisis is not over rates --at least not really ---
but over rationers flinch

ie
the banks not lending till the risk levels are clearer

this hiccup can cause a grid lock

and a value loss cascade

if the banks can be assured
worse case in 30 days
they hand over to the fed
their assets
ie
the MBS pile of crap

now they "might"
start to more freely lend
on the same assets

the beauty here is borrowing
low and short lending long and high

but the trick is to keep
the short lending " sources"
revolving thru the system
at a sufficiently growing rate .....
to fund the long term borrowers "needs "

only enough incoming funds
can turn the wheel fast enough

its all about enough

as in enough pull
to keep the moon revolving around the earth

is that clear ???

beyond that
its about real numbers

[dd]

Apparently not symbolic at all as Deutsche Bank tapped the window on Friday and it an interesting coincidence it had just hired Greenspan as a consultant the prior Monday.

[dd]

And in a further coincidence it was a signatory to the Major Derivatives Dealer industry practice letter of 3/10/06:
http://www.newyorkfed.org/newsevents/news/markets/2006/industryletter2.pdf

Wonder how many more will show up at the window and how that new settlement procedure following a "credit event" is working out.

[Ken Houghton]

The narrative neglects that most of the securities accepted for R/P by the Fed since August 10th--the previous Friday--were MBS. (See my graphic on the 17th.)

Last Friday looks like doubling-down when holding a pair of sixes.

The bad news just keeps on coming for Deutsche Bank.

[garhane]

It was charming to see the bald expression of classical bank thinking in the recent statements of the Governor of the Bank of England, Mervyn King, quoted in the BBC News web pages as stating that it was not the duty of Central Banks to protect financial institutions from the consequences of irresponsible lending decisions they had taken. I guess that covers all the banks, to name one group of such, who bought into the Mortgage subprime markets in the USA.
For instance, the Canadian Imperial Bank of Commerce. They are supposed to have dropped over 1 1/2 billiion. I hope to see King quoted so soon as they line up for some kind of "aid".

[TDDG]

I'm a bit frustrated by the number of commentators refering to the Fed's actions as a bail out of hedge funds. No amount of Fed activity is going to bring back a mezz ABS CDO's loaded with 2006 vintage RMBS. The hedge fund investing in this stuff is toast. BSAM's funds are worthless and they are staying worthless.

People I know in the hedge fund business are complaining that their haircuts are all being raised, if not credit lines completely cut off. But I see that as a normal strengthening of lending standards after a period of laxity. I think the Fed views this as a net positive development. They just want to make sure it happens in an orderly fashion, as opposed to a panic.

[Bruce Webb]

TDDGs take sounds right to me (like I know much).

I don't see this move as symbolic at all, particularly given the extention of the term from overnight to a renewable 30. And its not like it is free money, I am sure banks are not happy to see that 3% money walking out the front door to be replaced with 5.75% money. But it might keep Countrywides doors open. I say might because they announced 2500 layoffs (5%) this morning.

Friday's move may have removed the liquidity noose, but it doesn't look like Countrywide is breathing freely today.
http://www.ibtimes.com/articles/20061025/countrywide-layoffs.htm

[prostratedragon]

Yes, maybe not symbolic so much as specific. And a bit easier on the terms, though I doubt Fed will come close to taking Joe Doak's EZprime MBS as collateral.

(Too bad that html "sub" tag doesn't come out.)

[Dirk]

It strikes me that this is equivelent to the Iraq surge. A temporary measure designed to provide cover and enough stability so a "political" solution can be achieved. Let's just hope that the Investment Banks use their "surge" better than Malaki and Co.

[knzn]

"market downturns like those of the past few weeks often have only a small effect on businesses and consumers"

The same could be said for 25 basis point changes in the federal funds rate target. But a small effect is not the same as no effect.

[gordon]

In anybody reporting on the total value of loans the Federal Reserve is now making through the discount window at 5.75% against mortgage-backed securities? Has there been an ugly rush to the window?

In the future, it will also be interesting to see how many of these loans are rolled over for another 30 days, and then another 30 days...

Will the Federal Reserve return to pre-August-17 practices? If so, when?

Will the Federal Reserve move to ensure that rating agencies don't get too generous with their AAA rating from now on?

[gordon]

And what does the phrase "existing collateral margins will be maintained" in this Fed. Reserve press release actually mean?

[dd]

Gordon, if we knew then we'd be happily positioned. Transparency seems to have gone the way of the DoDo.

[gordon]

Answering my own questions dept.

This post at Econbrowser includes a reference to a Fed. Reserve statistical publication called Factors Affecting Reserve Balances (H.4.1), available here. The text of the Econbrowser post gives clues about what to look for. If I interpret correctly, total average discount window borrowing for the week ending 16/8/07 was $271m., which is the number shown against the heading "Loans to depository institutions". That appears to be where to look if your're interested to watch the reaction to the Fed. Reserve's actions of Friday 17 August. H.4.1 is a weekly publication.

[gordon]

Answering my own questions dept., Part 2

It appears that the phrase "existing collateral margins will be maintained" refers to this table (NB: .pdf) which indicates that discount window loans secured by CDOs and similar collateral will only be made up to between 80% and 90% of the face value (depending on exactly what type of collateral is presented). So banks using the window must accept a discount of between 10% and 20%, depending.