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Slaying The Two-Headed Dragon
The problems that exist today are akin to a two-headed dragon:There is a liquidity problem in the commercial credit markets and an overall economic problem (housing). If you want to know what the Fed's next move is, you need to understand what their actions today may mean for the liquidity issues affecting those credit markets. Allow me to offer a bit of an explanation. The discount rate is the rate at which banks may borrow directly from the Federal Reserve and this was the rate that was lowered by 50 basis points to 5.75 percent. These loans are typically made in an overnight timeframe-very temporary funds and they are securitized with either Treasury bills or mortgage backed securities garunteed by Fannie Mae or Freddie Mac. In addition to lowering the rate, The Fed also announced that it was changing the standard terms for these loans as follows: 1. Borrowing is allowed for up to 30 days, however, borrowing can be renewed at the option of the borrower (which is basically a revolving line of credit). 2.The Fed will now accept a wider variety of collateral, including asset-backed securities (CLO's), commercial mortgage-backed securities, and mortgage-backed securities (CDO's). Essentially what has happened is that The Fed has now provided some stability for the infamous mortgage backed CDO's that were instrumental in creating the liquidity squeeze to begin with. The Fed is doing this not by buying the paper, but by allowing them to be used as collateral for new loans to fund new mortgages. What this now means is that the wide array of CDO holders (the buyers) might be less inclined to sell those products into an illiquid market at a deep discount (loss), because the investment banks that sold the CDO's will now find it easier to obtain funding and make the interest payments on the tranches that stopped performing (sub prime). It may also help stop the investment banks that packaged all those mortages into CDO's from liquidating better performing assests. The move could also help prop up the value of the CDO market, as less pressure to sell will help to support price. However, this is only a partial solution to a two-pronged problem. Every sub prime mortgage that goes bad is a tiny dent in the CDO market, so the real key is to prevent further mortgages from going bad in the first place. There are several ways to do this including further open market operations and of course by lowering the target rate. Friday's moves will help stabilize the liquidity issues. Next will be a reduction in the target rate to help stabilize the economic issues. Caroline Baum in a Bloomberg opinion piece quoted Mark Gertler, a professor of economics at New York University and a frequent collaborator and personal friend of Bernanke's. Speaking of The Fed Chairman Gertler said "he is certainly attuned to how financial problems can spill over and affect the real economy...he's standing ready to adjust the funds rate if the stress is spilling over to the economy.'' Thanks for reading my post and please use the box on the left to vote. If you're interested in finding out more about my trade room, blog and trading primer, please contact Thanks and have a great weekend.
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