Fed saves the day or prolongs the pain?

On Friday the Fed announced:

For immediate release

To promote the restoration of orderly conditions in financial markets, the Federal Reserve Board approved temporary changes to its primary credit discount window facility. The Board approved a 50 basis point reduction in the primary credit rate to 5-3/4 percent, to narrow the spread between the primary credit rate and the Federal Open Market Committee's target federal funds rate to 50 basis points. The Board is also announcing a change to the Reserve Banks' usual practices to allow the provision of term financing for as long as 30 days, renewable by the borrower. These changes
will remain in place until the Federal Reserve determines that market liquidity has improved materially. These changes are designed to provide depositories with greater assurance about the cost and availability of funding. The Federal Reserve will continue to accept a broad range of collateral for discount window loans, including home mortgages and related assets. Existing collateral margins will be maintained. In taking this action, the Board approved the requests submitted by the Boards of Directors of the Federal Reserve Banks of New York and San Francisco.

OK that's wonderful but what is the discount window and how is this different from the open market operations the central banks have been performing over the past few weeks? This from the WSJ:

Explaining the Discount Window

The discount window is a channel for banks and thrifts to borrow directly from the Fed rather than in the markets. Until a few years ago, the discount rate was set below the fed funds rate and loans were subject to numerous conditions.

Banks were reluctant to access the window because it was associated with a stigma usually reserved for distressed banks. A few years ago the Fed overhauled the discount window to try and alleviate that stigma; the rate was then set one percentage point above the funds rate and subject to far fewer conditions. In spite of that, discount window borrowing has remained paltry.

Discount lending averaged just $11 million in the week ended Aug. 15. Although that was up from $1 million in the prior week it was puny compared to the billions of dollars the Fed has regularly injected into the financial system through open market operations.

Fed officials hope that reducing the penalty rate associated with the window and lengthening the term of loans to 30 days from one further lifts the stigma and gives it a tool to supplement open market operations for reliquefying markets.

Open market operations, under which the Fed buys and sells securities to adjust the supply of bank reserves and keep the federal funds rate on target, primarily operate through a network of primary dealers, some of whom are large banks. Thus, they have only indirect impact as a supply of funds for the thousands of banks that are not active in the money market. The discount window, however, is available to any bank or thrift, and the terms are easier than for fed funds loans. For example, banks may submit mortgage loans, including subprime loans that aren’t impaired, as collateral, and many probably will.

Discount window programs have, in the past, been added or modified temporarily in response to special circumstances, such as the century date change rollover (1999) and problems in the farm credit system (mid-1980s).–Greg Ip

OK, so what this essentially means is credit has become easier to get, because of less restrictions and the fact that institutions can go directly to the Fed.

Once again no-one is being bailed out here. The Fed is not wiping away billions of impaired MBS, CDO's and CLO's and effectively giving out get out of jail free cards. The Fed is providing short term funding which must be repaid in 30 days.

What if some instituitions don't pay their loans back in the specified time period? Well that would be a very silly move. Consider the Fed's circular 10 section 4.2 which states:

If all or any portion of an Advance Repayment Amount is not paid when due (whether by acceleration or otherwise), interest on the unpaid portion of the Advance Repayment Amount shall be calculated at a rate 500 basis points higher than the applicable rate then in effect until the unpaid Advance Repayment Amount is paid in full.

That's not a misprint, the penalty rate for for not repaying loans is 500 basis points or 5% - very costly indeed.

So isn't the Fed just prolonging the pain rather than saving the day? Well yes and no, rather than trying to save the day they are trying to restore some confidence to the financial system. They realize an unwinding of the excessive debt bubble they helped create and associated leverage has to happen, they just want it to happen in an orderly fashion.

However that may be wishful thinking. The problem is that the damage has been done. The dodgy loans have been made, the brokers have placed toxic debt in all corners of the world with the backing of the ratings agencies and the hedge funds are leveraged up to the eyeballs.

The creation of cheap money has come to an end and there is only one way for it play out. The money supply has to shrink and the unwinding of leverage has to take place.

Mark to market write-downs will occur and financial stocks will bleed red ink in the coming quarters. There will be many more bankruptcies with large players among them as the painful but necessary process unfolds.