Discount Rate Cut - So What?

The Fed cut its discount rate last week by 50 basis points (0.50%). Excuse my French, but... whoop-de-doo. For years now the Fed has been averaging around $200 million (that's "m" not "b") in very short term loans to banks, mostly O/N liquidity (see chart below, click to enlarge). The spike you see came right after 9/11 and was completely justified.

Discount Window Lending

The amounts involved are clearly insignificant and thus the rate cut was entirely symbolic. Unless, of course, we see a rush to the Discount Window to borrow in the billions, in which case we should all become highly concerned. No, scratch that, extremely concerned. Because it will mean that major banks are in deep trouble and can't borrow on their own.

Here is what the Fed itself has to say about the Discount Window:

"The Federal Reserve expects that, given the pricing of primary credit, institutions will not rely on the Discount Window as a regular source of funding. Though institutions are not required to seek funding elsewhere before requesting primary credit, primary credit is intended to be used mainly on a very short-term basis, usually overnight, as a backup source of funding. Primary credit is available for a period of up to approximately one month to generally sound depository institutions that cannot obtain funding in the market on reasonable terms. Ordinarily, this will be relevant only for very small institutions."
(Bold added)

So, keep an eye on this amount - you can get it weekly from the St. Louis Fed FRED program here.

Another item to watch is what kind of collateral is used to borrow from the Fed's Discount Window and at what prices. In recent years the Fed has accepted bank loans as collateral, plus the usual assortment of Treasurys, corporate bonds, GSE's and other ABS's. The collateral is supposed to be marked to market and the Fed will then lend anything from 60% to 98% of that value. Here's the catch: who determines the current market value for a CDO-cubed that no one wants to make a market in, or has a ridiculous two way price, like 40-90? How about a package of sub-prime loans?

Ahhh, but aren't we ever so clever? The Fed allows Discount Window borrowers to use collateral even if there is no market price available, using a uniform haircut of face value (par) depending on the asset class. For example, AAA CDO's and CLO's are assumed to be worth 85% of face. Individual mortgages...91% of face value. Home equity loans...89% of face value.

Stop laughing now...this is serious business. Because at these prices, I would tender as much as I could to the Fed, borrow up to my eyeballs and then keep their money and let them seize the collateral. You think...? Naaaahhh....