So the Fed opens up the discount window, and drops the rate 0.5%, banks go gonzo, right?? Well, no, I wouldn’t call it a “brisk business.”? A lot of the “business” was in and out in short order, for average borrowings of $1.2 billion.? For the discount window of its own to make a real dent in monetary policy, we would need to see more than $10 billion of net borrowings, because the Fed is decreasing the monetary base by $10 billion through other actions.? As it is, after the discount rate was decreased, there was a flurry of action, and then nothing.? So, in order to keep the monetary base up, the Fed injects temporary liquidity of $17.25 million, the most in 2 weeks (i.e., since permanent temporary injections started).? Does this have a big impact on the Fed funds rate?? No, it closes out the day at 4.875%, which is close to the average level of 4.90% over the past two weeks.? The number looks big, but it is meaningless.? Look at the monetary base or one of the monetary aggregates; they haven’t moved much.? Should we expect a lot of incremental economic action of out of this?? I don’t think so.

Onto the Commercial Paper Market.? CP outstanding had its biggest weekly drop since 2000. It is down almost 10% over the past two weeks.? Most of the decrease is asset-backed CP.? Bill Gross declares that the ABCP market is “history.”? He’s wrong.? Again.? ABCP will remain but with safer classes of asset-backed securities, wider spreads, and larger margins of safety, at least until the next lust for yield comes upon us. ;)? As it is, the safer parts of the ABCP market are beginning to function normally, albeit at higher spreads.

Things can get bad in the ABCP market, particularly if you are an issuer that doesn’t have a big balance sheet.? That’s what happened to Canada’s Coventree.? For banks issuing ABCP, it should not be as big of a problem; many banks will step up and make up the loss.? If the risk is $891 billion in commercial paper, I would be surprised if the losses were more than 2% of that amount.? At $18 billion, that is no threat to the system, though some rogue money market funds might get whacked.

Now corporate bond issuance is returning, though some of it is replacing CP.? I expect that effect to stop soon.? Things are returning to normal in corporates, though high yield will take more time.

This article helps point out that the Fed, though still powerful, has reduced powers because less of the financial system consists of depositary institutions. ABS and mutual funds have picked up the slack.? What that implies is that ordinary bond buyers are willing to take on the risks that depositary institutions once did.? That reduces the power of the Fed.

As for this article, I’m sure Fed Governors are thinking, “What’s next?? Are we just running from fire to fire, or is there a systemic way to restore order?”? I’m not so sure here.? I think a permanent injection of liquidity would do it, temporarily, but there are so many places where leverage got too great that are in loss positions now.? For the Fed, the only real question should be, how much did our banks lend to the overleveraged?

From Michael Sesit at Bloomberg, there are four things for the central banks to do in order to avert the crises: The world’s major central banks face four challenges as they strive to prevent the global financial system from unraveling and growth from stagnating: Acting in a concerted manner; improving transparency; deciding who gets bailed out and who doesn’t; and making sure whatever monetary medicine is administered doesn’t come with destabilizing side effects.

All four are not easy.? I would argue that the last two are the most important, but that it is very difficult to legally discriminate between who needs it and who doesn’t.? Destabilizing side effects are part and parcel of monetary policy.? To the degree that the Fed can discriminate, it will eventually run the risk of being view as unfairly discriminatory, and unelected as well.

So, I don’t see much happening here from monetary policy.? It is simply a question of how the excess leverage presents itself through the financial system.? So far, it has served up some notable troubles, the question is how much more before it burns out.? With residential housing prices sagging it may persist for a long while, until the Fed debases the currency such that debtors can pay back their debts in devalued terms.? It almost reminds me of the bimetalism of the late 19th century; debasing the currency to let a wide number of debtors off the hook.? Well, if the Fed doesn’t do it, maybe Congress will.? After all, Congress can do something targeted,and live with the political heat.? The Fed risks its independence if they look like they behave on behalf of the the few, nor the many.

1. There was a decent amount of attention paid to this blog post from the WSJ Marketbeat blog. The sentiment for a cut from the bond and futures markets stems from the concept that what the Fed has done is inadequate to reliquefy the areas that they are targeting. Banks will face significant lending losses, and economic growth will stop, unless the FOMC acts in a major way. We are still waiting (since 5/3) for a permanent injection of liquidity, and we have until Thursday night to see how much good the discount window action has done.
2. From the “not much good” camp, what good is it if healthy institutions pick up additional excess liquidity at rates above where they could they could borrow unsecured for 5 years in the bond market? Bank of America did not need the discount window down by 0.5% in order to take a stake in Countrywide.
3. Here’s the current problem. It has been difficult for marginal borrowers to borrow in the Commercial Paper [CP] markets. Even strong names like American Express and Lincoln National went to the bond market to pay off maturing CP. But if you were a lower rated company, things were worse, like H&R Block, or GMAC, things are considerably worse. All they can rely on is pre-existing credit lines. After that, they are dependent on the kindness of strangers.
4. Now, there is some hint that the troubles in ABCP are becoming more nuanced. Conduits with the highest quality collateral are getting rolled over. But how bad is it for real offenders? It is one of those cases where the ratings agencies are playing catch-up, let us say. Moves from AAA to CCC? Yes. Breathtaking. Sure ruins their ratings migration tables.
5. For those with time, for a relatively complete article explaining some of the problems that money market funds face from subprime, look here. The risk isn’t the same risk as from asset-backed CP [ABCP] per se, but seems to stem from buying AAA floating rate bonds from CDOs owning tranches of subprime ABS.
6. Those worrying about the carry trade blowing up can rest for a while. The Bank of Japan decided not to tighten. Japanese lending rates remain low a while longer, and the party goes on. I guess it will take the importation of inflation to make that change.
7. Beware easy certainties. Just because the Fed cuts does not mean the market will rise, or that if it doesn’t cut, it will fall. On average, it is true the 6 months after a first cut, the market rises, and almost always rises after a full year the first cut.
8. I previously asked who could benefit from incremental US dollar liquidity. I came up with a few possibilities, but one I did not come up with was Hong Kong, with their link to the US Dollar on one side, and their link to Chinese growth on the other. It is certainly worth a thought.

Full disclosure: long LNC

Only time for one post tonight.? I had a late meeting with some men from my church.? Away from that, my oldest son goes to college for the first time tomorrow, to St. John’s in Annapolis.? I will miss him, even though I will see him most weekends; he is a joy of a child to be around, and a really sharp thinker.? As an intern, he has impressed two investment firms with his acumen.? But what I will miss most is his good character.

Into the fray, then.? It’s the WSJ’s word, but is the Fed genuinely hopeful?? If so, it’s on scant evidence.? Away from that, you have Governor Lacker, who tends to be a hawk, saying that it is the effect of the financial markets on the economy will drive Fed policy, not any volatility in the credit markets themselves.? Well, the present dislocation is worse than LTCM in many ways already.? LTCM did not gum up the mortgage repo market, or money market funds.? As it is, Central banks are still showing themselves willing (minus the Bank of England) to engage in a series of short term injections of liquidity.

Why are money markets doing badly?? Asset-backed commercial paper [ABCP] makes up 50% of all money market fund assets, and those claims will have to be rolled over the next 1-3 months.? At a time like like this, the lack of alternatives is driving money market funds to grab T-bills and highly rated CP, even as those with higher ABCP exposure wonder what will happen if the ABCP conduits extend the obligation, and at the end of the extension period, are still inverted?? What will those that have to provide liquidity or credit support do?? This problem is not limited to the US; there have also been problems in Canada and Britain, but banks operating there have stepped up and taken the hit themselves.? Altruistic in the short run, but regulators and business partners have long memories, even when it is only implied promises getting broken.? (Hey, maybe the Fed can open up the discount window to non-bank ABCP conduits.? Please don’t… 🙁 )

At a time like this, is it any surprise that the guy who created the money market fund is saying that the concept has been abused?? It was not meant to fund speculators in risky asset classes.? Not all ABCP does that, but that is what some of them are proving to be now.? But, perhaps it is fitting in its own warped way.? The introduction of money market funds (and the elimination of regulation Q, a ceiling on credited interest rates) helped prolong the inflation of the 70s, because the Fed couldn’t control liquidity the way that it used to; money market funds just kept supplying liquidity at interest rates investors found attractive.

So, how tight is US monetary policy?? If you gauge it by T-bills, pretty tight.? At every percentage rise in the Treasury less fed funds spread like this, the Fed has loosened.? It could be different this time, but if so, the markets will be jolted, and by markets, I mean the debt markets, the money markets, etc.? The stock market will be down too, but that will be the least of our worries.? Even now, other types of consumer lending are starting to tighten.? With the markets already discounting a 50 basis point decrease in September, those markets will be tighter still if the Fed sounds like Governor Lacker.

So things are bad in the US.? How about elsewhere?? WestLB CEO Alexander Stuhlmann says that he sees an increasing reluctance to lend to German banks.? The Bank of England lent to Barclays plc at a penalty rate at their discount window, and supposedly for no big reason.? (I hope the reason is innocent incompetence… I’m a shareholder.? Oops, there’s the h-word again, and it’s me.)

The carry trade is getting squeezed, partly because currency option volatilities are rising.? How does this work?? Think of it this way.? The carry trade works by borrowing in a low interest currency, and investing in a high interest currency.? Assume for a moment that I approximately matched the maturities of the two trades (risk control!), but that I wanted downside protection from the trade going wrong, so I would buy an option that would stop me out at a certain level of loss (again, attempting to match trade maturity).? The higher the option volatility goes, the more costly it is to limit the risk on my trade, so as option volatility rises, the willingness to do the carry trade falls.

Chinese Inflation? ? As I’ve said before, that is a threat to the recycling of the US current account deficit, and also a threat to US inflation levels.? Could that keep the FOMC from loosening?? Not yet.? We need to see more pain here.

Finally, from the “don’t bite the hand that feeds you file,” the Bush Administration is worrying about the impact of sovereign wealth funds exerting undue influence on the US.? Oh, please, you worry about this now, after expanding our current account deficit like mad?!? At this point, the US has few options but to sell assets to all but dedicated enemies of the US; if we are not willing to cut back our current account deficit in other ways, and our debt becomes unattractive, there are two choices, let the dollar fall until US goods become compelling (with rising interest rates and inflation), or let them buy our assets.? We can’t freeload on the rest of the world forever (though we did sell much of the toxic CDO waste to unsuspecting naifs, we just don’t know who yet), eventually we will have to be willing to sell away large stakes in major US corporations.? (Or maybe all the surplus homes! 😀 )

Full disclosure: long BCS