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December 3, 2007

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.

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