“Stocks soared Friday, propelling the Dow Jones industrials up more than 180 points, after the Federal Reserve, acknowledging that the stock market’s plunge posed a threat to the economy, slashed its discount rate by a half percentage point.”
“The Fed cut the discount rate to 5.75 percent from 6.25 percent, declaring that “downside risks” to the economy have increased appreciably.
However, the central bank did not change its target for the federal funds rate, which has remained at 5.25 percent for more than a year. Many strategists believes the market won’t settle down until the Fed lowers the fed funds rate — the rate banks charge each other on overnight loans. The discount rate only covers loans the Fed makes to banks.”
“Bonds fell, with the yield on the benchmark 10-year Treasury note rising to 4.70 percent from 4.66 percent late Thursday.” (Stocks jump on discount rate cut)
Someone in the countrywide discussion below this one posted this link, which I am reposting here for those who didn’t see it. It describes the actual effects of the “cut” as described by various economists and the like, as well as some thoughtful reader comments below.
http://blogs.wsj.com/economics/2007/08/17/economists-react-lifting-the-wizards-curtain/
A summary of the comments is as follows: this was largely a symbolic move that would really only benefit anyone or change anything if a major lender was about to go under.
Some of the individual’s quotes are as good as the experts. It’s a great read. Kudos to the person who posted it in the other thread.
Here is a shining example from PropertyShark of how things are developing in SF. A pretty decent 1236 sft condo at 1330 De Haro on Potrero Hill is now in foreclosure. I don’t see the precise numbers, but it looks from tax records like the guy bought it in 2003 for about $600,000 or a little less. Not too expensive. But the foreclosure listing indicates that he has refinanced twice since purchase — last time in early 2006 — and now owes $1,015,000 on the place. He owes $400,000 MORE than he paid for it. It is not just those who bought at the hyper-inflated 2005-06 prices who are going to be hit hard. Lots and lots of places will be hitting the market because they did just what this guy did and used an affordable home as an ATM to make it unaffordable.
Yup.
And this guy will be on TV blubbering about how the mortgage brokers abused him and how he needs a bailout in order to avoid losing his home when in fact he walked away with 400K in free money.
“Here is a shining example from PropertyShark of how things are developing in SF”
Ahhhh, statistical significance. Sample size = 1.
A sample size of 1, but a good data point nonetheless – and there will be many more.
I see that the guy did a refi in March 2006 with Option One Mortgage. I just read that H&R Block is “scrambling to sell its MONEY-LOSING Option One Mortgage unit to a hedge fund” but it goes on the say the sale will likely be delayed. Guess the buyers aren’t lining up. Maybe John Edwards will want to get back into the mortgage business after he drops out of the 08 presidential race.
Another example from PropertyShark to add to the sample of 1. 138 Milton Street is also in foreclosure. Owner bought this SFR in 1997 for $188,000 — dirt cheap. But now it is being foreclosed with an outstanding mortgage of $571,000! I know — now I’ve just pointed to a statistically insignificant sample of 2 (in about 3 minutes of poking around on PropertyShark). So let’s just say it is my prediction that the trickle of refis that the owner can no longer afford will become a steady stream (if not a flood) joining the steady stream of ’05-’06 purchases at unaffordable/inflated prices with loans that are now re-setting at even more unaffordable terms. Take the added supply and couple it with a plunge in demand as lenders tighten standards and downpayment requirements, and one can see the obvious downward price pressures.
[Editor’s Note: While we normally remove duplicative comments from multiple posts, in this case we’re actually republishing a comment from “ex SF-er” as it’s directly relevant and worth the read.]
Can someone with deeper knowledge explain how a 50bp discount rate cut will help any of this in the long run?
Pardon my naivete, but the discount rate applies to Fed loans to “credit worthy banks”, so if you are a lender/bag-holder in trouble, how does this cut help you specifically?
WARNING LONG POST:
I’ll try to answer this how I am reading it, but please don’t take this as gospel.
I will start by stating that I am not a specialist in Federal Reserve operations, and also that I believe that the Fed is somewhat divided in how they should approach this. As example, Bill Poole, outspoken hawkish voting member for the Federal Reserve, was REPLACED for this vote presumably so that the Fed could vote unanimously for the discount rate cut. Due to internal divisiveness, it may be impossible to accurately say why the Fed does what it does
That said, here is my take.
The Federal Reserve has a few different mandates,
-to conduct the nation’s monetary policy,
-to provide and maintain an effective and efficient payments system,
-and to supervise and regulate banking operations
http://www.dallasfed.org/fed/understand.html
Many people reinterpret the above to mean: “to ENSURE PROPER AND SMOOTH WORKINGS of the credit markets”.
Over the last few weeks, we have seen a progressive and major breakdown in the credit markets. Originally, it is easily argued that the breakdown was APPROPRIATE. In other words, it was appropriate for certain poor-quality mortgage products to not trade well. The companies that dealt with that toxic garbage took huge losses, and it was appropriate, so despite their cries for help, the Fed did nothing.
however, this is spreading rapidly. At this time due to FEAR in the marketplace, there are many TOTALLY different types of products that are not trading well at all either (that “should” still trade ok)
one of those products (and the most important to this long post) is called “Commercial Paper”. Commercial Paper (henceforth called “CP”) is KIND OF like a line of credit that a big business often uses to finance it’s day to day operational expenses.
CP is usually short term (from a few days to a few months) and a big business will often keep a CP line open with one or several big banks and use it all the time. the rates of CP are typically far cheaper than comparable lines of credit or loans.
The Banks make money from the interest on the CP, and ALSO the banks often get paid a fee for all of the available CP that ISN’T used… overall CP is considered “safe” because only the biggest/best companies get to have CP lines, and it’s short duration. The companies with CP lines benefit because they have a cheaper source of funding of their operational expenses.
THE PROBLEM:
Subprime happened, and then Alt A, and then Jumbo loans happened. Now there are lots of securities (lots of “3 letter words” like MBS, CDO, CDS, synthetic CDS and so on) that are barely trading at all. Due to this, many big banks and other financial powerhouses DON”T KNOW how much their portfolios are worth, and DON”T KNOW how much losses they might have and DON”T KNOW how much risk they have in their portfolios.
due to this, many of the “big boys” are afraid to purchase securities, ANY securities… even securities such as CP, even though CP really doesn’t have much to do with mortgages at all. There is simply FEAR about any security
So now there are problems with the CP security market… and the CP isn’t trading well. Due to this, at first the crappy mortgage companies can’t “roll” their CP… in other words their financing costs on their daily operations just SKYROCKETED. (they have to use other methods of funding, which have higher rates and are more costly). As the crappy companies lose their CP lines, they approach bankruptcy, which sends a shudder through the CP market (remember, the CP market is supposed to be “safe” so a near-bankruptcy is very bad)
Now, due to the bad company CP problems, fear spreads to the better company CP market. So even “good” companies (like Thornburg Mortgage, which has a great portfolio) can’t get their CP funded. The concern is that this might continue to spread… maybe so bad that the CP market FREEZES as well, and then other companies that have nothing to do with this at all(like Prctor and Gamble to MAKE UP an example)
———————
So now what happened this week:
This week CountryWide showed some cracks. Their secondary market for their mortgages SHUT DOWN. Thus, they had all these mortgages that they couldn’t sell. which meant that they have MORTGAGES on their books, but no CASH to pay the rent/operational expenses. There was a concern they could be financially insolvent.
Due to the new situation, it’s debt was DOWNGRADED. By being downgraded, CountryWide must pay MORE money for its credit lines. this obviously hurts their cash position. How will they fund their operational expenses and stay open????
One thing Countrywide did yesterday was to call in their dedicated lines of credit (the $11.5 Bilion from 40 banks). they could do this because the money was pledged to them. (if you remember above, I spoke about how some banks are paid for CP lines that are NOT being used… this is the downside to that for the banks!)
But $11.5 Billion isn’t enough. I don’t know how long CountryWide can survive on that, but NOT LONG. Thus, if they want to survive, they have to raise money (debt) elsewhere. I heard reports that they were being quoted 13%. That is not doable for them.
So without help, CountryWide goes under. If CountryWide goes under, MANY people in MANY security markets lose BIG money. But worse (for the Fed), the Commercial Paper is all worthless. This could potentially FREEZE the CP market totally. (imagine nobody funding GE or Microsoft’s CP needs!).
Also, CountryWide is a loan SERVICER. (they service more loans than anyone in the country)
So although CountryWide in and of itself is NOT too big to fail, it may be too big to fail RIGHT NOW.
and if countrywide is having these problems, then how many other banks are in trouble?
So the fed has 3 choices
1. do nothing. Countrywide may fail. CP market shuts down. total credit collapse. Dangerous
or
2. drop the Fed Funds Rate. This allows EVERYBODY (all the dirty hedge funds) to go back to crazy trading again, and it “bails out” all the bad guys, and we get massive inflation and the dollar tanks. also, the Fed said it WOULDN’T drop rates, so if it did drop the Fed funds rate people would FEAR that we’re in meltdown mode.
or
3. drop the discount rate. the discount rate allows BANKS (not everyone) to have a loan at a PREMIUM (it is HIGHER than the Fed Funds Rate, not lower) with GOOD collateral. thus, you don’t get hedge funds mucking around. Banks who don’t need it will just use the Fed Funds Rate. But a bank in SHORT TERM TROUBLE who CAN’T finance it’s daily operations, could turn in GOOD assets (like conforming loans, certain securities) and get a good short term loan (higher than the Fed Funds Rate, but probably lower than other options). this buys time. that’s it.
So in this case, the Fed bought CountryWide 30 days of operational expenses. (it can be renewed though). thus, Hopefully, Countrywide can find other sources of funding in the next 30-60-90-120 days, or they can be liquidated in an orderly fashion during that time…
It also is SYMBOLIC to show the market that it is benevolent and watching, but won’t bail out.
It also will help OTHER banks that are quietly suffering like Countrywide.
Now today, the Fed discussed with many of the Big Boys, to ENCOURAGE them to all borrow from the discount window. The reason: to act as smoke screen. if wells and Bear Stearns and Citi and Wachovia all borrow from the discount window, then a failing bank can also borrow from the discount window without everyone knowing that they’re dead in the water.
and lastly, the Fed hopes the drop in this rate will encourage the banks to LEND in the CP market again, getting that market going.
In other words:
keep letting housing get crushed
keep letting leveraged hedge funds get crushed
but save the CP market
sorry for long post, hope that helps.
To ex SF-er’s point. Even Fannie Mae is having trouble selling their ‘paper’.
Now these are ‘prime’ conforming mortgages and yet there does not appear to be any buyers for them. This means Fannie Mae will have to use other sources of funding temporarily until things settle down in the credit market.
http://www.marketwatch.com/news/story/fannie-mae-skip-august-debt/story.aspx?guid=%7BAB7F6BE0%2D8766%2D4E14%2DB7C1%2DE8E88ED7FB96%7D&dist=hplatest