Tuesday, December 16, 2008

The ROACH Motel in ACTION...

The ROACH MOTEL is a commercial bug removal product intended to trap cockroaches. But the the US BANKING SYSTEM has become a roach motel in another sense. The Treasury capital goes in but lending does not come out. Fed rate cuts go in but bank rate cuts don't come out.

The chart below shows the ever widening gap between the Fed funds rate (a rate exclusive to banks) and mortgage rates. Here we look at fixed 30-Yr and adjustable (1-Yr ARMs) rates.

In January of 2008 the Fed funds rate cuts stopping having any impact on mortgage rates. From that time on Fed rate cuts only widened the spread between the banks costs of funds and what the banks earned on funds lent (e.g. mortgages). Right now the SPREAD between a one-year ARM and the Fed funds rate is near FIVE PERCENTAGE POINTS.

This is adding to bank profitability. So rate cutting is another way to help banks, not the economy -or at least, not the housing market.

Rate cuts go in but they don't come out!

The Fed's decision today cuts the funds rate to a range of zero to 25bp. It cuts the discount rate by 75bp, underlining the message that this is essentially a 75bp rate cut.

The Fed says in its announcement that it expects to keep the rate down here for a long time, trying in effect to encourage long rates to drop.

The ten year note price rose on this announcement pushing the yield to 2.44%. Stocks popped after the announcement.

The Fed said this:

The Federal Reserve will employ all available tools to promote the resumption of sustainable economic growth and to preserve price stability. In particular, the Committee anticipates that weak economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time.

The focus of the Committee's policy going forward will be to support the functioning of financial markets and stimulate the economy through open market operations and other measures that sustain the size of the Federal Reserve's balance sheet at a high level. As previously announced, over the next few quarters the Federal Reserve will purchase large quantities of agency debt and mortgage-backed securities to provide support to the mortgage and housing markets, and it stands ready to expand its purchases of agency debt and mortgage-backed securities as conditions warrant. The Committee is also evaluating the potential benefits of purchasing longer-term Treasury securities. Early next year, the Federal Reserve will also implement the Term Asset-Backed Securities Loan Facility to facilitate the extension of credit to households and small businesses. The Federal Reserve will continue to consider ways of using its balance sheet to further support credit markets and economic activity.

Rate cuts, yes- but so much more
With this statement the Fed embarks on a no-holds barred posture to help the economy. The rate cut is the least of what the Fed is doing. Its statement about the expansion of its balance sheet is essentially a statement on 'quantitative easing.' This is a massive money and reserve creation move intended to help stimulate the economy. The challenge for the Fed will be the way it brings this program to an end. The problem with the Fed pushing rates so low and keeping them there is that once the program becomes effective rates will have to shoot up sharply. For the time being there is little evidence that rates this low with all their attendant risks are helping anything. It's a lot of risk to take to cut rates in a way that the public does not seem to be sharing in the reduction as much as the banks. Of course if the 'public' does not share in receiving these low rates there is less risk for 'the public'.

The DANGER here is that anyone that manages to borrow at these low rates will find once the economy turns around, rates will rise sharply. So be careful of borrowing at these low rates - if any bank will share them with you.

Notice that in the Fed's announcement it says the resumption of sustained growth and preserving price stability are its main focus. It has not forgotten about price stability, despite the risks here.