I’ve now heard from two sources that mortgage lending in the SF Bay area is effectively dead. As the second put it:

Jumbo loan processing in the Bay Area, as far as they know, is completely halted. 20% down will NOT make the cut. It is more like 50% down and FICO score of above 750 plus full doc, and the bank may still think about it.

– OO, on Patrick.Net

Now that that spigot has been tightened down, there still remains the question of how to clean up after the excesses of the past few years. This morning’s sudden news of a cut in the discount rate has been taken by many as a sign of capitulation by the Fed, as were its repo operations the week prior. I think this conclusion is premature.

First, I want to emphasize that last week’s liquidity injections were short term operations; loans that came due the very next business day. This week’s rate cut was not to the federal fund rate, but to the discount rate. One of the roles of the Fed is to act as a lender of last resort, and to that end they provide the discount window. There is some stigma attached to the use of the discount window, as it presumably would only be used by a bank when all other sources of funding are exhausted.

These operations provide liquidity, but do not have the impact on the money supply that lowering the federal funds rate would. The need for liquidity can best be understood in the context of certain rumors. The first came last Wednesday, and suggested that WestLB, the third largest bank in Germany, almost went under due to exposure to the U.S. subprime contagion. That was completely unsubstantiated, but we do know that another German bank, IKB, did require rescue after its Rhineland subsidiary collapsed. We also know that the European Central Bank found it necessary to provide about $340 billion in liquidity over the next few days, an amount that would make sense if indeed a large bank found itself in trouble.

Economists distinguish between liquidity crises and insolvency/debt crises. An agent (household, firm, financial corporation, country) can experience distress either because it is illiquid or because it is insolvent; of course insolvent agents are – in most cases – also illiquid, i.e. they cannot roll over their debts. Illiquidity occurs when the agent is solvent – i.e. it could pay its debts over time as long as such debts can be refinanced or rolled over – but he/she experiences a sudden liquidity crisis, i.e. its creditors are unwilling to roll over or refinance its claims. An insolvent debtor does not only face a liquidity problem (large amounts of debts coming to maturity, little stock of liquid reserves and no ability to refinance). It is also insolvent as it could not pay its claim over time even if there was no liquidity problem; thus, debt crises are more severe than illiquidity crises as they imply that the debtor is insolvent, i.e. bankrupt, and its debt claims will be defaulted and reduced.

– Nouriel Roubini, August 9, 2007

Roubini’s quote above explains why a lender of last resort is necessary; if lenders are unwilling to lend, either because they cannot spare the funds or bear the perceived risk, the financial system can shut down, even if the participants should be able to pay their debt over time. This is clearly an undesirable outcome. By providing short term liquidity, a central bank is able to avert such crises.

It is likely that many of the participants in the credit derivatives market will also find themselves insolvent once their portfolios are properly marked to market. I also would not be surprised to find a major investment bank among the casualties. At times like this, there is often call for a bailout. Such an action would be a tremendously bad idea, which is why I am gladdened that the Fed has so far resisted calls for a rate cut.

“Financial markets have dealt harshly, but on the whole appropriately,
with banks, hedge funds and certain other investors who were heavily
exposed to the riskiest segments of the non-prime securitized mortgage
market.”

– William Poole, President of the St. Louis Federal Reserve Bank

Even ignoring the traditional arguments against a bailout, the moral hazard it creates and the corresponding increase in inflation, there is a much more immediate concern. To lower rates devalues the dollar with respect to other currencies. In the past day, the dollar fell to new lows against the Japanese yen, quickly passing through what was once considered a danger zone for the yen carry trade. (This is the practice of borrowing low interest rate currencies and investing them in higher-yield instruments such as U.S. Treasuries. Often described as “picking up nickels in front of a steamroller”, it is extremely vulnerable to exchange rate changes.) A rapid unwinding of the carry trade should be considered a worrisome credit event in its own right. Almost a decade ago, such an event seized up global markets, caused the multi-billion dollar collapse of LTCM, and incidentally bankrupted the entire subprime mortgage industry.

Hopefully this column in Barron’s is correct, and that we see a return to the Volcker tradition.

Friday’s action of lowering the discount rate a half percentage point, to 5¾% from 6¼%, adheres to the first principles of central banking going back to Walter Bagehot — lend freely in a crisis, albeit at a penalty rate to ensure these borrowings aren’t abused. The Fed’s target for the fed-funds rate remains unchanged at 5¼%.

In that, the Bernanke Fed returns to the practices under Paul A. Volcker, Greenspan’s predecessor and arguably the most effective chairman in the Fed’s history.

– Randall W. Forsyth, writing for Barron’s