Trader’s Narrative

So after the Fed cut rates as expected, and the market was miffed that it wouldn’t be enough to remedy the credit crisis wreaking havoc in the financial sector.

And then a day later the Fed came out with all guns blazing, with their international “friends” in Switzerland, Canada, Europe and England by their side.

But, to paraphrase Austin Powers, “Whoop Dee Doo, But what does Global Coordinated Liquidity Injection really mean, Bernanke?”

Since I’ve already explained the sub-prime market in simple terms, lets see if we can also explain this new Fed maneuver.

Federal Reserve Discount Window
Before we get to the explanation of what the global central banks will be implementing, we need to understand what the discount window is. Normally banks borrow from each other, or the fixed income market when they need capital. The discount window at the Fed is an option of last resort for banks what can not find financing using normal channels or anywhere else for that matter.

Although the discount window has been open, the rate reasonable and the need beyond extreme, no significant amount has been drawn through it by any major bank.

Global Coordinated Liquidity Injection
So why would banks act so stubbornly? Why sit there and bleed slowly? Or seek capital elsewhere at much higher rates than the Fed’s discount window?

It turns out that banks, unlike the current batch of Hollywood starlets, are prone to public embarrassment. The stigma of having to rely on the generosity of the Federal Reserve is too much They fear that were they to seek out this available solution, they would expose themselves to evaporating public confidence.

Shhhh, It’s A Secret
The coordinated liquidity injection allows banks to access the discount window with anonymity. So they can borrow at below interbank rates, using the same collateral that they would put up in a discount window transaction, but the transaction is secret. No one will find out who and how much… and so, no stigma.

There will be four auctions of $20 each. The first will be next Monday, the second December 20th for $20 Billion each. The third and fourth will be contingent on the evolving international credit situation.

Private Banking
Reminds me of the time I had to withdraw a rather large sum from a European bank a few years ago. Since this was the first time for me, I was a bit nervous. I didn’t want to stand at the counter while the money was given to me in open view of everyone. I didn’t know they have special rooms in the back for these sort of transactions.

Walking to the back was an interesting experience. No music sounds sweeter than the whirring of counting machines. Walk in with a briefcase, walk out with a briefcase. No public scrutiny. No one the wiser that the briefcase was a little bit heavier than before.

I have a feeling that many US banks are now running towards their favourite central bank with very very large briefcases.

I can’t believe that I actually agree with Jim Cramer on something. I’m breathing through a brown paper bag as I type this but there’s no way around it. He makes too much sense this time.

If you want to know what I’m talking about, check out this clip where he loses it talking to Erin about the inaction of the Fed. In the top video it looks like he’s going to have an aneurysm! It’s difficult to concentrate on what he’s saying and not on how he’s saying it. Then there’s the follow up (second video on the bottom) where he explains himself - this time with less emotion.

What he refers to is the “discount window” which according to the New York Fed :

…functions as a safety valve in relieving pressures in reserve markets; extensions of credit can help alleviate liquidity strains in a depository institution and in the banking system as a whole. It also helps ensure the basic stability of the payment system by supplying liquidity during times of systemic stress.

If that doesn’t describe what we’re going through, then I don’t know what will.

I don’t think Cramer is saying that the Fed should write a blank check to the market so that it can take on any and all manner of risk. What he is saying, and what I agree with, is that in times of stress to the system, the Fed should step in and act to reassure the market. Although as an economist Greenspan was a brilliant political operative, he understood this key point and was always there personally to ensure that all the key players knew it.

Right now the market is screaming at the Fed to reduce rates. The bond market is on the precipice of a real liquidity crunch which could reverberate throughout other markets and the whole economy. And it seems like the Fed is asleep at the beach.

I don’t think this is the end of the world. Nor would it be if the Fed continues to be hands off. But I’m sure that it would stabilize the fixed income market for them to have some sign that the Fed’s got their back.