Throwing a Bone To A Starving Dog

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There sure has been a lot of nonsensical gibberish flying around the financial infomercial media, and in the world of blogs and message boards since Friday. So let’s try to separate fact from fantasy.

We’ll start with something I agree with. I do believe that the Fed’s action had everything to do with Countrywide’s bank arm, the well publicized run by their customers, and the fact that they were forced to borrow apparently all of their $11 billion bank credit facility. This is a dangerous and volatile mix in the arena of the public confidence game that fiat money systems depend on. The Fed had to do “something” to give the world the impression that they were actually “doing” something.

What did they actually do? Not much.

Countrywide Securities Corporation is one of the Fed’s 21 primary dealers. They are a direct participant in the Fed’s daily open market operation repo auctions. If the Fed was going to prop up anyone, this group would be first in line. And given that the vast majority of Countrywide’s assets are residential MBS, clearly they would stand to be the first of the first in this situation. The Fed’s actions on Friday were designed to soothe the fears of the biggest financial actors, the market, and the public in regard to the apparently sudden meltdown of this one particular bad actor.

But the Fed did not lower rates. It didn’t even increase the monetary base. It just put on a show designed to keep the public con going.

Any depositary institution can borrow at the discount window, but it is essentially only an emergency facility for banks that do not have access to the Fed Funds market for whatever reason. The rate at the discount window has been set at a premium of 1% above the Fed Funds rate since the Fed changed the policy on use of the discount window in January 2003. All Friday’s move effectively did was to lower the premium for these emergency loans to problem children by 1/2%. And right now Countrywide is the Fed’s seriously delinquent teenager in big trouble with the law.

So is the Fed’s action as a big deal as the market’s subsequent action and the punditic (yeah, I just made up that word) euphoria would have you believe?


The Fed does not buy securities at the discount window. It makes emergency loans there, and since the rate is at a premium to the market, no one would use the Window if they weren’t in deep squat and were locked out of the Fed Funds market. How much lending is done at that Window? As of Wednesday of last week the total outstanding was $294 million. Not billion, million! Compare this with the total size of the Fed’s asset base of over $800 billion, and you get some idea of how truly insignificant the Fed’s symbolic ploy was.

But the market took the bait, hook, line, and sinker. The flipping and flopping will be something to see when the fish have their oxygen cut off.

I’ve seen a lot of misinformed discussion that the Fed is signaling that it is or will be buying the bad MBS securities. Not only does the Fed not buy bad securities, the Fed does not buy MBS securities. At least they haven’t yet. They hold no such securities in the System Open Market Account. In fact, as this accounting shows, they reduced the SOMA by over a billion in the week ended 8/15, and cut another $6 billion on Friday. In a move that I missed during the week, the Fed took the rare action of not rolling over about a billion of its maturing Treasury notes. They virtually always roll over 100% of the maturing paper they hold in the SOMA. The action of allowing paper to expire unannounced is a stealthy way of cutting the monetary base without anyone noticing. So, while the Fed Funds rate had traded well below the Fed’s target of 5.25% throughout the week, by Friday’s Open
Market Operations they had gotten the rate back to 5.35%.

This is not a sign of a Fed that has eased policy. Maybe that will change next week, but all we have so far is a few skillfully placed words designed to keep the con going. It’s a bit of a chess game. The Fed made its move, and now they will wait to see how the market reacts. If the boyz on Liberty Street and Wall Street are now patting themselves on the back at the moment, I suspect their self congratulations will be short lived, because there really is a liquidity crisis out there. There’s simply too much bad paper not paying the claims against it, and not being worth what the mark to model fairy tale said it was worth.

The market’s recovery was based in part on the expectation that the Fed may buy some of the bad MBS paper and magically transform bad to good. That expectation is likely to be one of those false assumptions that George Soros talked about. He said something to the effect that it is the speculator’s job to recognize the false trend, ride it, and exit before the crowd wakes up. I haven’t done the charts yet this weekend, but I suspect that the trend driven by this false premise may last all of a day and a half. We’ll see.

My guess is that the Fed will allow the worst of the crap credit and the crappy players to disappear from the firmament, but will save its firepower to save the biggest players in the banking system when the time comes. And that time is coming.

I was away from the trading screens Friday afternoon, and I was listening to Gloomboomberg in the car. (I like Gloomboomberg Radio by the way. They tend to do real reportage and be pretty even handed.) One of the pundits (I think McCulley of Pimco) made the point that the real reason for the rally was the Fed’s statement in the morning, because the Fed suddenly woke up and found that the downside risk to the economy had ”increased appreciably,” which was a big change from their more muted statement regarding downside risks at the Fed meeting last week.

Well, Surprise, surprise surprise! Can you imagine that?

Here’s what they said.

Financial market conditions have deteriorated, and tighter credit conditions and increased uncertainty have the potential to restrain economic growth going forward. In these circumstances, although recent data suggest that the economy has continued to expand at a moderate pace, the Federal Open Market Committee judges that the downside risks to growth have increased appreciably. The Committee is monitoring the situation and is prepared to act as needed to mitigate the adverse effects on the economy arising from the disruptions in financial markets.”

The players took this as a signal that the Fed will cut the Fed Funds rate imminently and that that is wildly bullish.

It sounds to me that the Fed was saying that the Wall Street Journal’s ”Best Economy in World History” may just be on the verge of collapse. The market’s knee jerk reaction was to judge that as bullish.

We’ll just have to see about that. As to the market’s apparent judgment that this was a policy loosening, the Fed stopped using the discount rate to set policy in 400 BC. Friday’s move was not a policy move. The Fed just cut the premium at Benny’s Pawn and Discount Drive Up Window for Problem Children — a mean, futile, and stupid gesture.

So far in this crisis, the Fed has NOT injected one cent of liquidity into the system except for that two day bulge on Thursday and Friday August 9-10, which they completely removed by Monday and Tuesday 8/13-14. The Fed remains tight in terms of the SOMA, and making matters worse, foreign central banks are dumping Treasuries to raise cash for injection into their own system in order to try and fix the extreme dollar squeeze in European credit markets. Last week they reduced their custodial holdings at the Fed by a record $17 billion. They actually sold $22 billion of Treasuries, but apparently the Asian central banks are still propping the GSE market as they bought $5 billion in Agencies.

We’ll just have to see if the world’s central banks have the firepower to stop a worldwide credit crunch and liquidity squeeze when some major players are essentially insolvent because dey ain’t no assets backing those ASSet backed securities. Rather than taking decisive action, it looks to me like the Fed is frozen in place like a deer staring into the headlights of an 80 mile per hour downhill runaway tractor trailer, while the ECB is fighting its crisis the only way it can, by selling Treasuries and injecting the cash into their system.

The fact is that the Fed remains shockingly tight in terms of the monetary base, which they have maintained at ZERO growth for the past 8 months, and LESS THAN ZERO in the past week when the sheet was hitting the fan. Sure that can all change next week, but you wouldn’t know it from the actions they took on Friday.

At this point, the cut at the discount window looks like nothing more than throwing a bone to a starving dog. Big freaking deal. Watch what they do, not what they say. It seems to me that they either don’t yet have a handle on the magnitude of the crisis, or they think that smoke and mirrors will fool everyone into thinking that happy days are here again and that the credit markets will “unfreeze” as a result. But so far, they haven’t “done” anything.

Finally, put this in your pipe and smoke it. This hasn’t been reported in the media but last week a $9 billion fund of hedge funds made a cash request of $500 million from the institutional money market fund where they hold their idle cash. For the first time ever, this fund of funds didn’t receive the cash immediately. As of Friday they had been waiting two days. They are still waiting, and there has been no word on how long it will take until they get their money. This is a fund that earlier took a $600 million hit on the Amaranth fiasco. And they are still waiting for the $165 million or so that they were supposed to receive from the liquidation.

This is just one fund folks. There are others in similar situations, perhaps hundreds, perhaps thousands of funds.

The run on the bank is only just beginning. Is the Fed’s Friday smoke and mirrors act going to change that?

I doubt it.

Lee Adler is the Editor and Publisher of the Wall Street Examiner and Wall Street Examiner Professional Edition. For daily updates on this ongoing saga get a risk free trial to the Wall Street Examiner Professional Edition Money, Liquidity and Real Estate service.

Lee Adler

I’ve been publishing The Wall Street Examiner and its predecessor since October 2000. I also provide analysis and charts for David Stockman's Contra Corner which I developed for Mr. Stockman. I’ve had a wide variety of finance related jobs in the past 44 years, including a stint on Wall Street in both analytical and sales capacities. Prior to starting the Wall Street Examiner I worked as a commercial real estate appraiser in Florida for 15 years. I also worked in the residential mortgage and real estate businesses in parts of the 1970s and 80s. I have been charting stocks and markets and doing analytical work since I was a teenager. My perspective is not of the Ivory Tower. It is from having my boots on the ground and in the trenches of the industries that I analyze and write about today.