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In the Wake of the Discount Rate Cut


We have been witnessing the phenomenon of deleveraging and if history is any guide this rarely occurs smoothly, or without some effect on the wider economy.

The biggest question over the weekend was whether the engineered discount rate cut by the Fed was enough to safely say the lows were put in last Thursday. There are reasons to be skeptical in looking at the market players and the Federal Reserve.

We have been witnessing the phenomenon of deleveraging and if history is any guide this rarely occurs smoothly, or without some effect on the wider economy. It is hard to imagine that what took years to create is over in a few weeks. The ability to slice and dice risk and spread it around has me questioning the vulnerability of the economy.

In addition, there are clear signs that the pain is spreading from hedge funds to banks. The total amount of rescue financing has placed tens of billions of dollars at risk for many of the biggest banks. Most charge nominal fees for the guarantee of liquidity and some banks did not properly reserve for the risk since the prospect of default seemed remote.

Citigroup (C) and JPMorgan Chase (JPM), for example, have guaranteed more than $90 bln of liquidity, or about 5 or 6% of their total assets, according to a recent Banc of America (BAC) Securities report. State Street, a custody bank, guaranteed about $29 bln, or 23% of its total assets.

That has ignited fear that the subprime contagion has spread to the global banking system - and, some suggest, caused the Federal Reserve Board to take action Friday.

"The Fed is concerned because of the banks' exposure. The banks are on the hook for potentially tens of billions of dollars," said Christian Stracke, an analyst at CreditSights, a fixed-income research firm. "That could tighten credit conditions significantly if all that paper is tied up in things that none of the banks want to hold.

Bernanke's Fed

The perception that the Fed will bail everyone out is still in the background for many, but if Bernanke turns out to be more like Volcker than Easy Al, as I wrote on August 13, then the current Fed will inject liquidity when needed but may quickly remove it when markets stabilize.

Mr. Bernanke may not follow in the footsteps of the former Fed chairman and provide what fondly became called the "Greenspan put." Under that philosophy, whenever a crisis brewed Greenspan would slash the Fed funds rate and provide cheap money to those who needed it as well as those who used it to add on layers of derivative speculation.

The Greenspan put helped during crises such as the 1987 stock market crash and the 1998 Long Term Capital Markets hedge fund fiasco, but it also built up a huge speculative fervor and added on layers of risk that would not be there if cheap money had not been available.

Friday's move by the Fed to lower the discount rate, not the Fed funds rate, made liquidity available to banks and depository institutions. They could borrow against collateral, such as asset-backed securities, but the important distinction is that this discount window is not available to the more speculative group such as hedge funds and in this sense is quite different from the insurance that Greenspan provided.

We are going forward confronted with decisions to make both with our portfolios and with daily trading. I am approaching the markets as if I am still walking in a minefield and highly alert as to where I step. Listening for further news from institutions holding subprime debt as well as the language and actions of the Fed will be paramount as to how I navigate this treacherous terrain.

During the day I am trading "light and tight" meaning small positions with tight stops. I still believe we are at the beginning, not the end, of a volatile time in many asset classes and we should not get lulled into complacency if markets are calm for a week or two.

That said, my other twin always reminds me I am too close to the game and I am reminded of the words from Julian Jessop of Capital Economics, as he puts it rather directly: "People in financial markets always think they are more important than the real world." Ouch!
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