SuddenDebt has amazing analysis on why the Fed cut the interest rate 50 basis points on Tuesday. Seems there's more than just hedge funds and real estate problems on the horizon...
The Real Reason For The Fed's 50 Basis Point Cut
Occam's Rule: Sometimes the truth is so simple that even as it stares us in the face we are blind to it.
The Federal Reserve cut its Fed Funds benchmark rate by 50 bp to 4.75%, more than most analysts' expectations. Already there have been trillions of pixels written to explain why, but none that I have seen follow the time-honored Occam or KISS principle (Keep It Simple, Stupid). Here is a chart that explains the FRB's move; for the non-professional there is an explanation after it.
The chart above shows the interbank money market yield curve for US dollars, from overnight (O/N) out to 12 months. These are the rates that banks charge each other to borrow for the period specified. When you hear LIBOR mentioned (London InterBank Offered Rate), these are the rates they refer to. The money market is by far the most important in the world, the very foundation upon which banking and finance rest, because it provides the day-to-day financing that keeps the wheels of finance and commerce spinning. It is normally a very mundane and boring market, a sort of meat and potatoes process that just works day in and day out. Think of it as finance's equivalent of the electrical power plant, i.e. it is taken for granted - until something goes wrong. Any trouble in the money market is immediately transmitted via the banks to the bond and stock markets and then quickly out to the "real" economy. So what does the above chart tell us?On September 12 the money market was truly ugly, with a big "hump" in the cost of money from 1 month out to 6 months. The spread in interest rates between 3 months and O/N was almost exactly 50 bp. The reason was that Asset Backed Commercial Paper (ABCP) that typically came due in 30-90 days was not being rolled over and everyone was scrambling for money to replace it. This is also why the ECB was constantly pumping huge amounts of money into the system: it was bailing out the banks' SIVs that could not find any money to replace their ABCPs (I wrote elsewhere that the ECB was doing the Fed's laundry - this is the reason). At a borrowing cost of 5.70-5.80% against assets that yielded maybe 5.50% and leveraged 10-20x, various SIVs and other borrow short - lend long players were bleeding money like crazy. The situation was indeed critical and the cost of money had to be brought down sharply or the banks would have to sell collateral (CDOs, CLOs, etc.) in a depressed market and write huge losses in their books - If they could find a buyer, that is. So the cost of money was brought down. Clearly 25 bp would not have done the trick - just look at the chart - and so the Fed cut 50 bp. It's as simple as that. Nothing to do with the economy, jobs, retail sales or the cost of peanut butter in Peoria. Ain't the truth fun? So now what? As you can see from the blue line, the "hump" is still there but it is much smaller. The banks have been given some breathing room and can keep those CDOs, CLOs, etc on their books more comfortably. But - there is always a but - the mass of ABCP and ABCP-type financing has now shifted to the O/N market, i.e. it rolls daily because lenders do not trust them and want to be able to pull their money out ASAP. This type of financing from one day to the next is very dangerous: if there is another credit crisis like we saw two weeks ago, such lenders will demand their money all at once, in the same day.
To draw a parallel, say everyone has to drive to work every day but gas stations only provide each customer with enough gas for just one round trip. It is easy to imagine what will happen if gas runs short...Let me say one final thing: most people are not fools. If bankers and politicians try to instill a false sense of confidence by claiming things are different than what everyone knows, they lose credibility. Do it too much and people get really worried and think: defense (i.e. I want my money NOW). Most people know houses are too expensive, most people know there is way too much debt and just about everyone knows that financier pay at a billion dollars a year isn't sustainable. SuddenDebt
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