Federal Reserve Increases Rate at Which Banks Can Borrow From It

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Marked up Discounts

Monday began with jitters over the market’s reaction to a raise in the U.S. discount rate. In other words, the Federal Reserve increased the rate at which select banks can borrow from it.

The so called ‘discount window’, was intended to be an emergency lending facility. The lender of last resort. Instead, it’s become the lender of any resort. The increase in the discount rate means it won’t be as cheap to borrow money from the Fed.

The relevance to you shouldn’t be underestimated. Aussie banks get much of their funding from overseas, so they are affected by what happens in the global interbank market. If the increase in the discount rate is a signal that the broader interest rate is going to be raised as well, then this would affect the availability of funds and their cost.

In a debt drugged, liquidity obsessed world, a change in interest rates can go from affecting profitability to affecting solvency very quickly. And it’s not just the banks that are high on cheap credit. Take a look at a listed company’s balance sheet. Most of them use leverage to boost their returns.

Low interest rates encourage this.

The reason the western world economy has become particularly interest rate sensitive is because of the way it uses debt. Instead of funding an asset with debt and then paying it off with the increased revenue, more debt is used to pay off the previous borrowings as they come due. This is referred to as rolling over debt.

By doing this, a company (or government) is able to sustain a high level of leverage over time. The debt is never truly repaid.

But, if interest rates rise, then the cost of borrowing goes up. Traditionally, this would have decreased the amount of borrowing. In our modern economy more must be borrowed in order to pay off the old debt. That means companies have no choice but to accept a change in rates.

The financial market reaction to a potential increase in the more important Fed Funds Rate would not have been pleasant. However, this unpleasantness didn’t eventuate, indicating that financial markets expect rates to sit tight for some time to come. Based on this, Dan Denning is a step closer to declaring victory over our Money Morning editor Kris Sayce, with several beers at stake.

Neither editor is being suspicious enough in their analysis. Let’s take a trip down memory lane with a former Federal Reserve economist, Michael Belongia. What happened in the past when the discount rate was changed?

In this podcast, Mr Belongia talks about how a change in the discount rate can lead to a change in the actual interest rate without FOMC approval, or much media attention. Going behind the back of the FOMC, which is supposed to set the interest rate, is scandalous. That didn’t stop it from happening regularly, according the Belongia.

He explains that the spread between the discount rate and fed funds rate should be kept constant according to Fed policy. So, if the Fed’s Board changes the discount rate, then the Fed Chairman can march down to the Fed’s trading desk and instruct the traders to change the Fed Funds rate to maintain the spread. This conveniently avoids the often less complicit FOMC.

Belongia’s accounts are shocking to anyone who believes in the integrity of that particular institution and sickening to the sensible people who don’t.

As mentioned, governments around the world are also exposed to the problem of having to roll over debt. To Senator Joyce’s delight, the lucky country is no exception. Dan Denning points out that “… according to 2008 data, over $400.1 billion dollars of Aussie foreign debt – or 35.4% of the total – matures in 90-days or less. Nearly half the debt total – $514 billion – matures in one year or less.”

That’s a lot of debt to refinance on such a regular basis, so any change in interest rates will be felt quickly.

The press often refers to the shortening maturity of government debts. This implies governments will have to roll over debt more often. Such shortening has occurred in the U.S. and is now a major concern. Former Federal Reserve Chairman Alan Greenspan has referred to it as the “critical Achilles heel”.

The “greatest financial crisis globally ever”

On Tuesday, Bloomberg reported the confession of Kingpin Alan Greenspan. At least, we consider it a confession. Low interest rates have largely been blamed for the financial crisis by those who warned of its imminence. Greenspan set those rates artificially low. Often in a cunningly deceptive way, according to Mr Belongia. Anyway, here is how Greenspan’s conscience was finally cleared on Bloomberg:

Former Federal Reserve Chairman Alan Greenspan said the financial crisis was “by far” the worst in history and called the recovery from the global recession “extremely unbalanced.”

The world economy has undergone “by far the greatest financial crisis globally ever.”

Greenspan said that while the economy was in worse shape in the Great Depression, the recent financial crisis was potentially more harmful than that in the 1930s because “never had short-term credit literally withdrawn.”

Greenspan also said “fiscal affairs are threatening this outlook” for recovery, as Congress and the White House face difficulty raising taxes or cutting spending.”

So, not only is his reconciliation late, but his diagnosis is too.

Speaking of confessions, our other ‘favourite’ economist, former Enron adviser and Nobel Laureate Paul Krugman, has declared his ignorance publicly:

“I’m craving the chance to do some deep thinking, and I haven’t been doing a lot of that.”

While this fact is familiar to most, it does not excuse Krugman’s behaviour. Having consistently advocated the inflation of economic bubbles, to the devastation of homeowners, employees and shareholders around the world, he now advocates a level of government debt that would make Senator Joyce faint, or pop, whichever comes first.

But best of all is this part of Krugman’s article:

“I guess doing the really creative academic work does require a state of mind that’s hard to maintain throughout your whole life.”

Creativity! Economics and creativity? Economics is about understanding timeless principles. Perhaps this is where he went wrong – too much creativity. We have seen the results of Krugman’s creative solutions, indicating he doesn’t understand the economy, or wishes to indebt future generations beyond help.

Resources Comeback

RBA governor Rick Battelino explained that the resources boom has overcome an interruption known as the GFC:

… now that has passed, the underlying dynamics of the resource boom are starting to reappear…

It’s hard to put a finger on exactly how much investment is going to take place, but I don’t think it’s unreasonable to expect mining investments to rise to 6 per cent of GDP over the next few years. That would be about twice as high as it got to in the previous boom. It’s a very big boom.

It certainly is big. But so are China’s resource reserves.

In an article on oilprice.com, Dave Forest of the e-letter Pierce Points, warns of the potential price reaction should China decide to begin using those reserves, or even selling them. In fact, they may have already started, with vast steel exports going to Europe.

The effect a short term fall in commodity prices could have on Aussie resource investment and development could be pivotal to the future of the Australian economy.

China itself is of course an economic basket case, as cleverly shown in this business spectator slideshow.

Nevertheless, it seems a BRIC barbeque is roasting the PIIGS and may provide demand for resources to fuel their fire. (Thanks to Daily Reckoning reader Wayne for the inspiration on that one!)

Confidence

Confidence indicators took a hit in the U.S. and Germany, while U.S. new home sales dropped to a record low. This is particularly striking, as central banks often tout these two factors as their primary focus. “Restoring confidence in the market” and “supporting house prices” are phrases that echo through the halls of the central banks on a continuous basis.

Meanwhile, the US unemployment figures are proving disastrous, let alone the unemployment itself. The American Bureau of Labour Statistics has its own numbers in such a mess that the pollster Gallup has decided to help out.

The Poll informed the BLS that “nearly 20 percent [of the 20,000 adults in the work force polled] were working part time in January because they couldn’t find a full-time job or had no work at all, and that they are having trouble affording basic necessities like food, shelter and health care.”

This tells a different story from the BLS estimates of below 10% unemployment.

U.S. banks continue their slide into oblivion, with 4 of the 161 bank failures since 2009 recorded last week. The outlook isn’t much better. Bloomberg reports that “hundreds of banks may face insolvency as losses mount on commercial real-estate loans, according to a Feb. 10 report by the panel appointed by Congress to oversee the U.S. bailout program.”

Meanwhile The Telegraph uses some spectacular phrases in an article titled “Failure to save East Europe will lead to worldwide meltdown”. It even breaks the language barrier with the following: “…set off round two of our financial Götterdämmerung.” Götterdämmerung roughly translates to Godly twilight, implying an age of saviourless darkness.

Next up it suggests a “Monetary Stalingrad” and Eastern Europe “blowing up right now.” A more surgical approach was taken by Latvia’s central bank governor, who declared the Latvian economy “clinically dead”, while protesters “trashed the treasury and stormed parliament.”

Needless to say, an excellent article.

Strangely enough, stock markets remain comparatively buoyant and Australia seems to be trundling along happily. Whether Mr Market has sucked in enough suckers before another crash is unclear. Daily Reckoning editors would probably be more concerned if the media was more optimistic, as this indicates complacency.

The Economic Climate

Former IMF economist Jeffrey Sachs provided some creativity of his own in a recent article:

Climate change science is a wondrous intellectual activity. Great scientific minds have learned over the course of many decades to “read” the Earth’s history, in order to understand how the climate system works. They have deployed brilliant physics, biology, and instrumentation (such as satellites reading detailed features of the Earth’s systems) in order to advance our understanding.

The Guardian, points out otherwise:

Scientists have been forced to withdraw a study on projected sea level rise due to global warming after finding mistakes that undermined the findings.

This article was previously put forward as proof of claims made in the infamous IPCC report. The official withdrawal included the statement that “… it’s one of those things that happens. People make mistakes and mistakes happen in science.”

While we are in agreement that mistakes happen, we do not agree that government policy should be based on anything quite so mistaken. This is especially so, as government policy is more often than not an inherent mistake as well.

In keeping with brilliantly balanced and fair journalism, the Guardian published the article of Jeffrey Sachs two days before the article about the withdrawal of the study. I wonder what readers think of that.

In the name of financial stability!

Dan Denning also reported on the latest government scheme to support its funding aspirations:

Yesterday’s Financial Review even mentioned the possibility that a shrinking government bond market would be a problem for Australian banks. That’s because a new regulation proposed by the Australian Prudential Regulatory Authority (APRA) would require a certain percentage of bank assets to be made up of high credit quality bonds. And MBS.

MBSs are Mortgage Backed Securities, those things that have a habit of blowing up when house prices fall.

Acropolis Now

According to Porter Stansberry, the publisher of Stansberry and Associates Investment Research, the Greeks have pulled off a feat that would make Sun Tzu jealous. Greek military spending has been excluded from the annual budget, because it is a “state secret”. So, according to Stansberry, about 30% of the Greek governments’ spending isn’t even declared.

Nickolai Hubble
The Daily Reckoning Week in Review

Nick Hubble
Nick Hubble is a feature editor of The Daily Reckoning and editor of The Money for Life Letter. Having gained degrees in Finance, Economics and Law from the prestigious Bond University, Nick completed an internship at probably the most famous investment bank in the world, where he discovered what the financial world was really like. He then brought his youthful enthusiasm and energy to Port Phillip Publishing, where, instead of telling everyone about The Daily Reckoning, he started writing for it. To follow Nick's financial world view more closely you can you can subscribe to The Daily Reckoning for free here. If you’re already a Daily Reckoning subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Daily Reckoning emails.
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