Thursday, March 27, 2008

Has the Fed Removed Downside Risk?

I've been thinking about this portion of the latest Fed statement:

First, the Federal Reserve Board voted unanimously to authorize the Federal Reserve Bank of New York to create a lending facility to improve the ability of primary dealers to provide financing to participants in securitization markets. This facility will be available for business on Monday, March 17. It will be in place for at least six months and may be extended as conditions warrant. Credit extended to primary dealers under this facility may be collateralized by a broad range of investment-grade debt securities. The interest rate charged on such credit will be the same as the primary credit rate, or discount rate, at the Federal Reserve Bank of New York.

Let's take this one part at a time.

1.) There are two inter-related problems in the financing market right now. I call it C&C risk -- collateral and counter-party risk. Collateral risk is caused by all the junk paper out there (which everybody and their brother seems to own). This has led to the counter-party risk, where every lender is concerned that every borrower will default on even a short-term loan. Therefore, we're seeing a ton of cash hording right now.

2.) The Fed's action helps to alleviate that problem by doing three things. First, it opens the lending window to a wider audience. Now investment banks can borrow from the Federal Reserve. Secondly, it broadens the collateral the Fed sill accept. Essentially, borrowers can use a lot of the crappy paper out there (so long as it is investment grade or better) as collateral. Third, lowers the interest rate charged.

3.) What was the primary fear before the Fed's action? Default. What are the possibilities of a default in the current environment? Much lower. Why? Because if an institution gets in trouble it can use the paper that is probably causing at least part of the trouble to get a short-term loan from the Fed.

Does this prevent all problems? No. But it does alleviate the biggest fear out there right now -- a bankruptcy of a major Wall Street firm.