The Fed Rate Cut

The Federal Reserve policymakers voted unanimously for a half-percentage-point cut in the federal funds rate yesterday.

Here's what you need to know:

The gist: The Fed dropped its key interest rate from 1.5 percent to 1 percent in a bid to boost economic growth and increase the availability of credit. This rate cut follows a 50-basis-point reduction earlier in the month, when the Fed acted in concert with several central banks around the world to address what has clearly become a global credit crisis.

The Fed's decision met the expectations of a market that had rallied considerably in anticipation of the cut. The Dow gained 890 points Tuesday and was up another 230 points on Wednesday immediately after the announcement. (A sell-off shortly before the close left the index down for the day.) Notably, in its statement, the Fed hinted at further rate cuts to come.

What it means: The Fed clearly doesn't like what it sees in the broad economy. Its statement points to tight credit amid market turmoil, as well as declines in consumer spending, business equipment spending, and industrial production. The Fed also expressed a new concern about weakened economies abroad "damping the prospects for U.S. exports." The last time rates were slashed to 1 percent was 2003, when the market was trying to recover from the bursting of the tech bubble and to soothe investor anxieties after the 9/11 attacks. The rate cut comes on the heels of several ugly economic reports, including a record decline for the S&P/Case Schiller 20-city housing index for August and a record low for the Conference Board's monthly measure of consumer confidence.

What the pros are saying:
Ian Shepherdson, chief U.S. economist at High Frequency Economics"The rate cut is accompanied by a very downbeat statement, with all mention of upside inflation risks expunged from the record. Indeed, the statement says that the drop in commodity prices and the deteriorating growth outlook mean 'the Committee expects inflation to moderate in coming quarters to levels consistent with price stability.' Moreover, the door is open to further easing, with the [Open Market Committee] stating baldly that 'downside risks to growth remain,' thanks to the decline in consumption, 'weakened' industrial activity and worsening export prospects. In short, we view this as the first entirely realistic assessment from the Fed in this whole cycle. We expect another 50 [basis point drop] on December 16."
Robert Brusca, chief economist at FAO Economics"The Fed cut the discount rate by 50[basis points] as well and it got requests for FOUR district banks out of twelve on that. When the number of discount rate cut requests diminish[es], it is often a sign that the string of rate cuts is over."
Goldman Sachs U.S. Economic Research:"The most significant change in the statement announcing this move was the downgrading of inflation as a policy concern. Whereas the September 16 statement following the last formal meeting had indicated virtual parity between growth and inflation worries, this statement did not even mention inflation in the final paragraph summarizing the committee's policy framework.... Both the acknowledgement of growth as the main worry and the promise to "act as needed to promote sustainable economic growth and price stability" imply the possibility of additional rate cuts. At the moment, we think the bar to such cuts is probably high as suggested by the small number of banks applying for a 50[basis point] rate cut, and we are not forecasting more easing as a central scenario. However, risks clearly lie in this direction."
Bernard Baumohl, chief global economist at the Economic Outlook Group"The latest Fed move is not going to hasten the economic recovery by a single day or accelerate the cleansing of bank balance sheets. What is needed more than anything else at this stage is simply patience....
"Tomorrow we'll get GDP growth for the third quarter and we're looking for a contraction of 0.8%, largely on the decline of consumer expenditures—the first drop since 1991—along with slipping inventories and exports. We expect conditions will get even worse in the final quarter, with GDP growth contracting by 3%. The recession should bottom out in the first half of next year, as the emergency financial rescue package and the monetary stimulus work their way into the economy. This is not to say we'll see stellar growth in the second half of the year. Growth will remain below potential at least until mid 2010, which means joblessness will continue to rise next year, to 8%."
Michael Woolfolk, senior currency strategist at the Bank of New York Mellon"While the rate cut was consistent with expectations, the statement did little to signal the Fed's future intentions. Still, the Fed maintained downside risk to growth and removed its upside risk to inflation, which suggests the possibility of further rate cuts. The Fed clearly did not want to disappoint markets today by failing to cut rates. The futures market had discounted a 100% probability of a 50 bps rate cut and approximately a one-third chance of a 75 bps cut. The statement was reworked, but not to the degree that market conditions probably warranted."

The ABC of CDOs and the sub-prime crisis

In early 2005, the US housing market was booming. As conveyed by the June 2005 Time magazine’s cover title “Home $weet Home,” the housing market was minting money for everyone. Amid this, every individual in the US was living the American dream to own a house. Housing prices were consistently rising and appreciation was the highest over the past 30 years. This, coupled with historically low interest rates, prompted most people to buy “investment properties”. In the US mortgage market, by borrower quality, a mortgage is prime, sub-prime, or Alt-A. Prime borrowers are those who have good credit scores, a strong debt-to-income ratio, provide required documentation, tax history, residence records and so on. The mortgage is a first-lien mortgage. A sub-prime mortgage is to a borrower who does not qualify as per prime norms, or it is a second-lien mortgage. An Alt-A is to a borrower who is not necessarily poor quality, but does not qualify for prime lending due to documentation problems. Understandably, spreads are quite high in sub-prime lending; yet defaults were low largely due to home prices. Buoyed by this, US banks pressed the accelerator on sub-prime mortgage loans. The outstanding volume is estimated $1.8 trillion. Many of the mortgages originated in 2005 and 2006 had features to make the mortgage enticing — interest-only mortgage, negative amortisation mortgage and teaser-rate adjusted-rate mortgages.

Securitisation game:

A large part of money for this came from the securitisation market — that implies pooling together mortgage loans and issuing securities that are repaid from out of the cashflows of the mortgage loans. The proportion of sub-prime mortgage securitisation reached peak levels in 2005 and 2006. Roughly 60-70 per cent of the sub-prime mortgages were securitised.

Leveraged vehicles:

Securitisation transactions need first-loss support, that is, junior pieces which would suck losses in the mortgage pool upto a level that can make senior pieces safer. Who would buy these junior pieces? Here came collateralised debt obligations (CDOs). A CDO is similar to a securitisation transaction, except that its asset pool is not retail assets but mostly bonds and corporate securities. CDOs buying into other securitisation transactions are known as structured finance CDOs. Data indicates that structured finance CDOs grew very fast from 2004 — today, they form about 70 per cent of all CDO issuance. If CDOs supply equity to home equity securitisations, what provides equity to the CDO market? After all, the CDO also has subordinated tranches, rated like BBB or BB, which are meant to absorb the losses upto specific levels. The rate of return on these tranches could be upwards of 300 bps. Hedge funds saw an opportunity here. Note that the hedge fund also might leverage itself, and that is quite common. Now add up all the pieces of the leverage — a home equity mortgage is itself a leveraged product, as it might be backed by a second lien on the house. These are pooled into a home equity securitisation, which is a leveraged product. The equity of these is bought by CDOs, which are leveraged vehicles. The equity in CDOs is supplied by hedge funds, which are also leveraged. A $1 of equity in typical hedge fund might ultimately create assets of $1,000, implying a total leverage of a thousand times. The combined impact of economic leverage in the market today may put LTCM, the infamous hedge fund that went bust in 1998 mainly due to a hundred times leverage, to shame. Hedge funds and other yield-hungry investors found yet another way of betting on the sub-prime mortgage market — the credit derivatives market. Credit derivatives are derivatives that trade the risk of default of an entity or a security. Linked to a bunch of home equity securitisations, there is a credit derivatives index called ABX.HE. Trades in ABX.HE increased in 2006 and 2007.

The rout begins:

Circa 2007, the US housing market was declining. While increasing interest rates halted new origination volumes, foreclosure rates on existing mortgages of 2005 and 2006 vintage went up as they were to enter the floating phase, when rates of interest would be hiked. Delinquency levels have gone up to the highest levels, historically. And then the perfect storm began. Since different vehicles in the leverage game were all inter-connected, there is a chain effect building all over. Mortgage lenders are suffering losses; some have filed for bankruptcy, some have gone out of business, some have liquidated portfolios at huge losses, and so on. These include New Century (filed for bankruptcy), HSBC (provided huge losses), People’s Choice Home Loan (filed for bankruptcy), Countrywide Financial (suffered huge losses, credit spreads have almost doubled), Wells Fargo (quit sub-prime business) and Fremont (sold subprime portfolio at huge discount). Hedge funds suffered losses in either home equity securitisations, or trades in the ABX.HE; many have stopped redemptions and some have filed for bankruptcy. New issuances in the CDO market that supplied liquidity to the securitisation market dropped from $42 billion in June 2007 to $3.7 billion in July 2007. Rating agencies ruthlessly downgraded securitisation transactions and CDOs. Leveraged finance supply has crashed, putting off lots of acquisition financing plans. Credit spreads have gone up for most financial entities substantially. This might eventually lead to rising cost of capital for financial intermediaries. Funding costs for asset-backed commercial paper conduits, another vehicle that supplies liquidity to Wall Street, have gone up. The $1.15 trillion ABCP conduits have cost going upto 5.75-5.95 per cent compared to corporate commercial paper at 5.25-5.3 per cent.

Credit derivatives indices plummet:
As may be expected, sub-prime credit derivatives indices took a beating (see chart of ABX.HE which is linked with 20 home equity securitisation transactions).

Global implications:

The biggest worry is the contagion impact. There are two big reasons for worry: first, the level of leverage, and second, the nature of the vehicles that have created leverage in the market. As already indicated, the levels of leverage in the financial markets are extremely high. Leverage is a magnifier — it magnifies profits, and magnifies losses. Secondly, most of the leveraged vehicles we discussed have automatic deleverage triggers. When their assets suffer losses or decline in market value, they are required by their constitutional documents to reduce their asset size. In other words, they have to make fire sales, which further exacerbates the problems. The hedge fund industry exceeds $1 trillion in assets — some analysts predict that in next five years, that would be reduced to half. The hedge fund industry supplies the equity that holds the huge inverted pyramid of structured finance that Wall Street is. So, the worry that the problems that emanated in the sub-prime market might spread into a crisis of global scale is not entirely unfounded.