They’re Not Admitting It, But This Is How Bad The Collapse Is

They’re not telling you, but this is how bad the collapse is and what is being done to save the system.

June 16 (King World News) – Jeff Snider at Alhambra Partners:  In its earliest years, the Discount Window wasn’t something to be avoided at all costs, it was nearly the whole point. In order to supply largely seasonal liquidity, the word “discount” meant banks could show up at one of the local 12 Fed branches and post collateral for an increase in their reserve balance. No one would be stuck holding illiquid even short-term paper.

Operating on a loose doctrine of “real bills”, there wasn’t even much management required. Most of the collateral being handed over was self-extinguishing, an exercised letter of credit or temporary funding note for some real economy purpose. Along with promoting the market for bankers acceptances, the Fed’s job was to ensure there wouldn’t be a cash crunch by “rediscounting” these financial instruments with almost no questions asked.

So long as banks were making real bills, that is letters of credit for real economy projects and needs, the Fed stood by to provide any and all liquidity you’d ask of it…

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Control was instead imposed via the Discount Rate (raising it meant discouraging the practice of rediscounting by making it slightly more expensive) while credit risk was managed by administrative means (bank examiners, mostly).

After the Great Collapse into the Great Depression, the Federal Reserve was revamped closer to the structure we recognize today. The Discount Window was reimagined, repurposed to be the primary vehicle as this new lender-of-last-resort. Using the Federal Reserve to fund regular economic operations was suddenly frowned upon (it had a lot to do with the larger concept of “borrowed reserves” and federal funds, but we’ll save that one for a later date).

In January 2003, after decades of inept practice, the Discount Window was reimagined yet again. The reason was stigma. After having been encouraged into disuse, the supposedly primary emergency funding mechanism had mutated instead into a complete no-go zone; because the Fed doesn’t want you unless you’re in a dire emergency, by merely showing up at the window everyone is immediately alerted to your true situation.

Including all the rest of your funding counterparties; former funding counterparties, I should write.

To counteract the presumed negative forces of disrepute, the Greenspan Fed in 2003 slickly relabeled the Discount Window as Primary Credit (also coming up with a secondary avenue called, unoriginally, Secondary Credit) and rearranged its rate placement in the pecking order. Why, you ask?

The rule change to primary credit (why it is called primary credit) removed the restriction against relending any federal funds borrowed there. Prior, any bank borrowing at the traditional Discount Window was prohibited from further distributing those funds; again, last resort.

Because Primary Credit was believed to have cleansed the stigma of the Discount Rate coupled with the ability to relend, theoretically (and academically) it was expected that if money market rates rose above the Primary Credit “ceiling” other healthy banks would then borrow at the formerly Discount Window and relend those funds back into the market as an arbitrage of flow (acknowledging that the federal funds effective rate itself is not really a singular price but an attempt to aggregate and average many trades). Paired with the federal funds target (the policy rate), the new Primary Credit (and Secondary Credit) was meant to define a hard corridor for money market rates. Fragmentation was believed as a remote problem defined instead by these policy arb opportunities.

The Fed wanted to create a means whereby otherwise healthy and liquid firms would take advantage of the Discount Window, thereby borrowing an excess from the central bank and then relending to anyone in need of liquidity who might be afraid to access the program directly.

That’s where the ceiling idea essentially comes into play, since these healthy firms are borrowing from the Fed at the policy target plus a big spread (originally set +100 bps). Because there were theoretically no limits, and no restrictions upon relending, the good banks would borrow sufficiently from that level and keep the market as a whole stocked, albeit at a higher average rate, until whatever problem blew over and everything went back to normal….more here

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