Today, the FOMC cut the Fed Funds rate to 1.00% and the discount rate to 1.25%. The intent is to free up the credit markets. Unfortunately, this is an unlikely proposition. The FOMC's decision is akin to lowering the price of water when water is scarce. The problem is not that credit is too expensive, but that there is little available. To be sure, there is much capital available to banks, thanks in large part to an increasingly encroaching government, but banks are hoarding capital to help absorb losses due to writedowns or to acquire smaller, somewhat troubled, institutions.
There is little upside to lending money to bank counterparties of the public unless the borrower in question is of impeccable quality. Banks do not wish to be exposed to extraordinary counterparty risk (in the case of interbank lending) and investor aversion to mortgage-backed or asset-backed securities mean that securitization is difficult if not impossible. If banks cannot securitize mortgages, they soon run out of capital and essentially become income-oriented investors. A bank engaging in such business practices is not long for this world.
What about GSE mortgages? Why haven't GSE-qualified mortgage rates fallen? According to the Wall Street Journal it is because investors are unsure of the governments long-term treatment of GSE agency and mortgage-backed debt. As I have said many times, Mr. Paulson's and Congress's actions have eroded instead of bolstering investor confidence.
Further eroding investor confidence is the increasingly activist sentiments emanating from Congress. Initially, the government said it was taking a passive interest in banks receiving aid. This is evidenced by the non-voting shares being purchased by the government as part of the recapitalization plan. However, all is not what it appears.
Congress and NY State Attorney General Andrew Cuomo are imposing their will on the banks. The government wants to review Wall Street bonuses and severance packages. No vote is necessary. The government is imposing its will. This is the case for any bank which accepted assistance, including those who were forced by the Treasury to participate two weeks ago. This is not your father's America, but it may be your grandfather's (New Deal).
If cutting the Fed Funds and Discount rates will not help increase lending much, if at all, why bother? The answer is two-fold. First, doing so technically makes short-term capital more affordable although, with the Fed Funds rate already trading in the .25% to .50% area, today's ease will have little effect. Mostly, today's ease was done for psychological reasons. If the public believes the Fed is doing everything it can to fix the system, they may be more willing to invest in banks and provide capital. Maybe some potential home buyers re-enter the market feeling confident that we have bottomed. I believe this to be a mistaken belief and besides, fewer potential buyers can qualify for mortgages.
At some point, weaker borrowers will be foreclosed upon and weaker institutions will fail and then, after much pain, the recovery can begin.
Investors should be wary of investing on the log end of the curve. The printing or money / issuing of debt side is beginning to win the tug of war with the flight to quality. The lowering of short-term rates could hasten the rebalancing away from the dollar and could also help put the brakes on falling commodities prices. Stay short to mid-term and stay in high quality investments. High-yield bond defaults are likely to rise from their relatively mild current pace of approximately 5.00%.
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