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Central bank impotence and market liquidity
By Henry C K Liu

After months of adamant official denial of any potential threat of the subprime mortgage meltdown spreading to the global financial system, the US Federal Reserve (Fed) last Friday, a mere 10 days after declaring market fundamentals as strong and inflation as its main concern, took radical steps to try to halt financial market contagion worldwide that had become undeniable.

The Wall Street Journal (WSJ) reports that the emergency measures - lowering the discount rate - were hastily taken to promote what the Fed



publicly referred to as "the restoration of orderly conditions in financial markets". The telling words were "restoration of orderly conditions" in a market that had failed to function orderly. The Fed let the market know that it has shifted to panic mode.

Restoring disorderly market conditions
The WSJ reports that the crisis of disorderly conditions began two days earlier on August 16 in London where US$45.5 billion of short-term commercial paper issued by US corporations overseas was maturing, but traders had difficulty selling new paper to roll them over as they normally would have by noon time in London, or 7am in New York.

Demand for commercial paper had dried up suddenly in a tsunami of risk aversion. Less than half of the paper was eventually sold at distressingly high interest rates by the end of the trading day. At 7:30am in New York, Countrywide Financial Corp, the largest home mortgage lender, announced that it was drawing all of its $11.5 billion of bank credit lines because it had difficulty rolling over its commercial papers.

By noontime in New York, near the end of the trading day in London, the dollar fell against the yen by 2% within minutes to cause traders to rush to unwind their yen carry trade positions. Money rushed into three-month US Treasury bills, pushing the yield down from 4% to 3.4%, sharply widening the spread with corporate commercial paper, with some paper moving as high as 9.5%, which in normal times would be close to the Fed Funds rate, which now stands at 5.25%. By evening, Fed chairman Ben Bernanke of the Fed convened a conference call of board members. The next morning, the Friday, the Fed capitulated.

To ward off a market seizure, the Fed cut the discount rate at which cash-short US banks and thrift institutions can borrow directly from the central bank as a lender of last resort. The Fed announced that it would grant banks and thrifts such loans from its discount window against a liberal range of collateral, including technically unimpaired triple-A rated subprime mortgage securities of uncertain market value and liquidity.

The discount rate was cut from 6.25% to 5.75%, making it merely 50 basis points above the Fed Funds rate target, half of the normal spread for a neutral monetary policy. The Fed also extended the period for loans at the discount window from one day to up to 30 days, renewable by the borrower. These changes "will remain in place until the Federal Reserve determines that market liquidity has improved materially" and "are designed to provide depositories with greater assurance about the cost and availability of funding".

The New York Fed, which has the responsibility of operating the Open Market Committee to keep inter-bank rates close to the Fed Funds rate target by buying or selling securities and by making overnight loans in the repo market (see: The repo time bomb Asia Times Online, September 29, 2005 ), had injected substantial amounts of liquidity, $62 billion up to the time of the discount rate cut, by such means into the banking system in previous days. Earlier, the effective Fed Funds rate had traded at 6%, 75 basis points above the Fed target, as banks demanded higher rates to lend to each other.

The Fed then convened an extraordinary conference call for major money center banks to explain its latest move. It tried to encourage banks to use the discount window, saying to do so would be a "sign of strength" under current circumstances, not a sign of distress as in normal times where banks are conventionally reluctant to use the discount window, fearing that going to the Fed for cash might be interpreted by the market as a sign a distress.

The Fed said in a policy statement on the same day of the unusual discount window moves that financial market conditions had deteriorated to the point where “the downside risks to growth have increased appreciably”. The Fed said it is monitoring closely market situations and is “prepared to act as needed to mitigate the adverse effects on the economy arising from the disruptions in financial markets”.

The language of the 2007 Fed statement is an echo of Greenspan-speak. Notwithstanding his denial of responsibility in helping through the 1990s to unleash the equity bubble, Alan Greenspan, the then Chairman of the Fed, had this to say in 2004 in hindsight after the bubble burst in 2000: “Instead of trying to contain a putative bubble by drastic actions with largely unpredictable consequences, we chose, as we noted in our mid-1999 congressional testimony, to focus on policies to mitigate the fallout when it occurs and, hopefully, ease the transition to the next expansion.”

I wrote in ATol on September 14: “Greenspan's formula of reducing market regulation by substituting it with post-crisis intervention is merely buying borrowed extensions of the boom with amplified severity of the inevitable bust down the road. The Fed is increasingly reduced by this formula to an irrelevant role of explaining an anarchic economy rather than directing it towards a rational paradigm. It has adopted the role of a cleanup crew of otherwise avoidable financial debris rather than that of a preventive guardian of public financial health. Greenspan's monetary approach has been "when in doubt, ease". This means injecting more money into the banking system whenever the US economy shows signs of faltering, even if caused by structural imbalances rather than monetary tightness. For almost two decades, Greenspan has justifiably been in near-constant doubt about structural balances in the economy, yet his response to mounting imbalances has invariably been the administration of off-the-shelf monetary laxative, leading to a serious case of lingering monetary diarrhea that manifests itself in runaway asset price inflation mistaken for growth" (Greenspan, the Wizard of Bubbleland).
 
Chairman Bernanke has now summoned his own clean-up team into action. The Fed hopes that by assuring banks that they can now access cash on less punitive terms from the Fed discount window, collateralized by the full "marked to model" face value of mortgage-backed securities, rather than the true distressed value as "marked to market", for which they could find no buyers at any price in recent weeks as the market for such securities has seized up, it can jumpstart market seizure for mortgage-backed commercial paper and securities.

The Fed announced the discount rate and maturity changes a day after a video conference of its Open Market Committee in which the emergency action was "unanimously" endorsed by all voting committee members, except William Poole, president of the St Louis Fed, who had argued publicly a few days earlier against an emergency rate cut short of a "calamity" and who did not take part in the vote.

By its emergency actions, the Fed conceded the existence of a market "calamity". Equity markets around the world interrupted their week-long losing streak and rose reflexively on the news on the last trading day of the week, albeit doubt remains on the prospect that such market adrenaline is sustainable. The Dow Jones Industrial Average (DJIA) gained 233.30 points, or 1.8%, edging back to 13,079 on hope that the Fed has now finally come to the rescue of a collapsing market.

Still, the yield on the two-year US Treasury note fell four basis points to 4.18%, signaling continuing risk aversion in the credit markets and investor flight to safety, not even just to quality. Fed Funds futures indicate that the market expects several quarter-point cuts from the current 5.25% by the end of the year to keep the troubled economy afloat.

Unsustainable adrenaline
By Monday, the adrenaline already wore off and the Dow turned negative by noon on the first trading day after the Fed emergency actions. The flight to safety pushed the three-month Treasury yield to 2.5% at one point. It can be expected that sharp volatility in the equity markets will continue as announcements of assurance are issued by the Fed, the Treasury and key Congressional committee chairmen to temporarily boost the market on false hopes, only later to be brought back down to reality.

The market is casting a vote of no confidence in the Fed's ability to save the market. At best, the Fed can slow down the credit meltdown by extending it out into years rather letting the market execute a needed catharsis. It is not a scenario preferred by true free marketers.

No doubt the Fed has an arsenal of offensive monetary tools at its disposal. But just like the "war on terror" in which all the guns of the Pentagon can have no effect unless the military can find real terrorist targets, the Fed's monetary tools remain useless unless the Fed knows where to intervene effectively.

Just as terrorists morph into the general population to make themselves difficult to identify, the problem with structured finance is that by transferring unit risk to systemic risk, it deprives the Fed of effective targets to intervene on a systemic repricing of risk. When contagion has already spread risk aversion to all vital components of the credit market, containment is no longer an effective cure.

Financial health will continue to decline in the entire system until the risk appetite virus works its natural cycle. Excess liquidity is like a drug addition. It cannot be cured with another stronger additive drug by adding more liquidity. What the Fed is trying to do is not merely to restore market liquidity, but to preserve excess liquidity in the market. It is trying to avoid a crisis by setting the stage for a bigger future crisis.

Low interest rates hurt the dollar
The problem with the single-dimensional prognosis on the curative power of policy-induced falling interest rates on the ailing economy is that it ignores the adverse impact such interest rate cuts will have on the exchange value of the dollar, which has already been falling in recent years beyond levels that are good for the economy.

How the discount window works
Eligible depository institutions are allowed to borrow against high-grade collaterals directly from the Fed's discount window to meet short-term unanticipated liquidity needs. One category of these collateralized loans, termed "adjustment credit", comprises loans that are usually overnight in maturity and are made at an administered discount rate.

However, banks traditionally only make sparing use of the discount window for adjustment credit borrowing. The discount window is also used for seasonal borrowings, mostly associated with agricultural production loans, and for "extended credit" for banks with longer-maturity liquidity needs resulting from exceptional circumstances.

The most potent power bestowed by Congress on the Federal Reserve system is the setting of the discount rate. Raising the discount rate generally increases the cost of bank borrowing and slows the economy, while lowering it stimulates economic activity, since banks set their loan rates above the discount rate, and not by market forces.

In contrast, while the Fed Funds rate is also set by the Fed, it is implemented by the Fed Open Market Committee participating in the repo market to keep 

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