Will the Fed's $40 billion in short term loans break the credit logjam?

Posted Dec 19th 2007 8:27PM by Peter Cohan
Filed under: Morgan Stanley (MS)

By the end of this week, the Fed will have auctioned off $40 billion worth of month long loans to banks. The Fed got 93 banks to put in bids for $61 billion worth of loans on Tuesday -- an offering that was more than three times over-subscribed. The result was that the winning banks were able to borrow $20 billion at 4.65%.

Why is this significant? As I said on the lead story this evening on NPR's Marketplace -- click here to listen -- the Fed is trying to restore confidence among banks so they'll resume lending to each other. Banks are not confident lending to each other because of their subprime mortgage backed securities holdings. As we saw today, the writing down of the value of those holdings comes at a cost -- $9.4 billion for Morgan Stanley Inc. (NYSE: MS) for example. These write-downs reduce bank capital and banks don't want to lend to other banks if they're not sure the banks will repay the loans.

Since banks don't trust each other, the Fed wants to lend them the money they would have gotten from each other. The Fed has already made its Discount Window available to banks. This innocuous sounding term is actually an emergency means of pumping money from the Fed to the banks. But it comes at a high price. First, banks feel that there's a stigma associated with borrowing at the Discount Window. Second, 4.75% is perceived as a high rate. That's where today's auction comes into play.

The 4.65% rate at which the $20 billion was auctioned is lower than the 4.75% Discount Window rate. And it's much lower than the current rate that banks charge each other -- 4.93%. So banks lined up en masse for the Fed's auction. And they're likely to do the same tomorrow when another $20 billion goes up for bid.

I admire the Fed for trying to do something to restore banks' confidence in each other. But if estimates that the subprime mess will cost $400 billion are correct, then the $40 billion worth of loans that the Fed is making available this week will not do the trick. Instead, the banks need to get real and write down all their bad loans. Then the banks need to raise equity capital to make up for the losses in the wake of the write downs.

The Fed's $40 billion worth of auctioned loans are not equity. The money must be repaid in a month to the Fed. The question that remains unanswered is this -- what is the right source for the needed $400 billion worth of equity capital? Do we as a nation want to sell a huge chunk of our banking system to Asian and Middle Eastern nations? Or should we pony up some of our own money to keep the U.S. banking system in U.S. hands?

Peter Cohan is President of Peter S. Cohan & Associates. He also teaches management at Babson College and edits The Cohan Letter. He has no financial interest in Morgan Stanley.

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Reader Comments (Page 1 of 1)

12-19-2007 @ 11:04PM

MRBLUECHIP1941 said...

The Federal Reserve is out of control. It is trying to buy time to cheapskate bankers who trust no one. They disquise themselves in the auction market when stepping up to take their share of the public loot which Uncle Ben Bernanke is giving away. Problem is we still don't know where the snake pit's bottom is. Hyper inflation has to be the end result of Bernanke's actions.
When will the Federal Reserve realize it is the home owner who needs to be saved not Republican bankers and mortgage banks.
In short, the crisis continues? Flood the world with cash and save people not banks.

Just listen to Asian and European bankers and investors. They aren't buying Ben's efforts. They know our economy better than Americans do.
Jim Cramer of "Mad Money" , for once, should be listened to. His rantings and ravings this time may very well be called for. Bernanke has GOT TO GO.
Bernanke and Co. are a pack of jerks. It goes without saying that the Offal Office Occupant is an incompetent boob who should have been impeached and removed long ago. He stands buy unwilling to tax the super rich and veto Speaker Pelosi and Congressman Steny Hoyer's give aways and calls for higher taxes.
The GOP after next year's elections will certainly wish they had ended Bush's malfeasance in office much earlier. They are signing their political death warrants and they are stupid to realize it.