Inside the Credit Crisis: How the Fed's Efforts to Lower the Fed Funds Rate May Leave it Powerless to Stop the Financial Meltdown

Shah Gilani

By Shah Gilani
Contributing Editor
Money Morning

"The truth? You can't handle the truth."

The truth is, the U.S. Federal Reserve does not directly control the Federal Funds rate, and its efforts to reduce the benchmark rate from 2.0% to 1.5% may do more damage than good – though for reasons you'd never guess. Attempts to lower the Fed Funds rate could irreparably damage Fed credibility and may actually narrow the Fed's credit-crisis-management options.

The Fed Funds rate is the interest rate that banks charge one another for overnight loans. Under normal circumstances, the Fed Funds rate is the central bank's primary and most effective tool in influencing interest rates. But the current market situation is anything but normal.

Contrary to what most people think, the Fed Funds rate is a "target;" it is not an absolute number that anyone actually has to follow. The central bank's policymaking arm, the Federal Open Market Committee (FOMC), resulting principally from its deliberations on the outlook for inflation, and secondarily the general state of the economy, raises and lowers interest rates throughout the financial system and the economy by targeting the Fed Funds rate.

Before the U.S. financial markets opened on Wednesday, Fed policymakers, headed by Chairman Ben S. Bernanke, announced that the central bank was lowering the Fed Funds rate half a percentage point to 1.5%. The idea is that, the lower a bank's cost of money actually is, the cheaper the rate at which it can lend to others and still maintain a decent profit margin [For a complete discussion of cost of funds, and of the overall lending process, take a look at yesterday's Money Morning report on the commercial paper market. The report is free of charge.]  Banks compete with each other to make loans. If they have lots of money to lend, they compete for business by lowering the interest rates they charge borrowers. The more money banks have, the lower interest rates go.

If the Fed lowers the rate at which banks borrow from one another, it stands to reason that banks will generally pass their lower cost of money along to borrowers. And that means the lower resulting interest rates will stimulate capital formation, production and consumption – and with it, the entire U.S. economy.

Well, at least that's what's supposed to happen. But here's how it really works.

 Every major bank has a Fed Funds trading desk. The job of a bank's Fed Funds trader is to buy or sell money overnight, or for longer periods. There are two reasons why banks buy and sell money:

• First, if a bank has money in its vault that it could – but hasn't – lent out, that money does the bank no good just sitting there, not generating any interest income for the institution. So the bank's trader actually calls around to other banks to see who wants to borrow some money.
• The second reason is actually far more critical and is always the bank's first consideration: The Federal Reserve requires that banks keep at least a specified minimum of reserves in their vaults. That means that each and every evening, as the Fed tucks a bank in for the night, it always makes sure to ask: "Have you met your reserve requirements tonight?" If a bank has made a lot of loans that day, it may be short of cash to meet its reserve requirement ratio. If that happens, the bank's Fed Funds trader calls other banks and borrows enough money to cover its reserve requirements.

Generally speaking, the interest that banks charge each other is close to what we know as the Fed Funds rate. If the Fed lowers the Fed Funds rate, theoretically the cost of money at which banks lend to one another is lower, too. In theory, then, if all banks have met their reserve requirements, and if they all have money to lend to each other overnight, and because money that doesn't get lent out doesn't make any interest, banks will lower interest rates for borrowers so that the money in their vaults is put to use and earns interest.

Here's the rub. In order for the Fed to actually change the Fed Funds rate, it must itself go out into the market and buy and sell securities. The Fed executes open market operations through the New York Federal Reserve Bank, the most powerful of the 12 Federal Reserve Banks.

If the Fed wants, as it does now, to lower its Fed Funds target rate, it has to initiate the process. In order to add cash into the banking system, the New York Fed buys Treasuries from dealers and pays cash. The transaction is called a repurchase agreement, or "repo." The result of this transaction, when done to the tune of billions of dollars, is that dealers now have billions in cash that they can deposit into banks. Since, banks theoretically now have a lot of cash to lend to one another overnight, they will lower the overnight rate that they charge each other.

The Fed must inject enough excess cash into banks' vaults through its open-market repo operations to make sure the banks actually lower the overnight rates they charge one another until that rate approximates the central bank's Fed Funds target rate. That's the reality of how the target rateis reached.

But, as usual, there's the story – and there's the story behind the story.

Traditionally, when the Fed executes repurchase agreements, it buys U.S. Treasuries and pays cash for them. The Treasury securities the central bank buys becomes part of its balance sheet. Now, however, dealers and banks are loath to sell any Treasuries. Why? Because Treasuries are the only security on dealers' and banks' balance sheets whose actual worth they know. They're not parting with them.

Because the Fed is determined to add liquidity by providing loans and easily marketable securities to banks and dealers through its discount window and term auction facility, it is already taking in all manner of other securities, including equities, against which the Fed is lending Treasuries from its own balance sheet. If the Fed wants to lower the Fed Funds rate, and dealers and banks aren't going to sell it any Treasuries, the central bank will have to take in other securities (toxic junk) as collateral against the cash that it hopes to inject into the banking system through its repurchase agreements.

Just how depleted and how damaged the Fed's balance sheet may become is a major concern. But, that's not the immediate problem.

Lowering the Fed Funds rate may not work at all.

Just because the Fed floods banks with cash doesn't mean that banks will lend each other money – at the targeted Fed Funds rate, or at any rate. Banks are all fearful of each other – I'm talking on a worldwide basis – they are increasingly hoarding cash as a cushion against their own upcoming losses. They're facing increasing weakness in their commercial-loan and commercial mortgage-backed securities inventories (the next shoe to drop). And banks are increasingly facing heightened exposure to leveraged loan portfolios on their books that they can't off-load, and rapidly deteriorating credit-card-based securities and portfolios.

If the Federal Reserve is unable to facilitate overnight-bank lending, and is unable to actually lower the Fed Funds rate to its target rate of 1.5%, what will that do to its credibility? It is devastating that we have no trust in our banks; but if we also lose trust in our central-bank firefighter's ability to quell the financial conflagration, the darkening skies may make the last three weeks seem only partly cloudy.

The Fed and the U.S. Treasury Department have done a good job in addressing, publicly, what needs to be done. Unfortunately, they have both made the cardinal sin of actually showing us their hands, when they should have played their aces earlier and controlled the game.

Now the whole world is watching.

And since we know the hand we're all playing, it's only a matter of what cards are turned over that will determine our future.

On Monday, I'll show you the Treasury's hand and tell you why that game is already lost.

We need to drop these games, reshuffle the cards and play this out as the "house" with greater odds in our favor. It can be done by Election Day, but we're going to have to take the politics out of the game – once and for all.

Can we do it?

[Editor's Note: Contributing Editor R. Shah Gilani has toiled in the trading pits in Chicago, run trading desks in New York, operated as a broker/dealer and managed everything from hedge funds to currency accounts. In his just-completed three-part investigation of the U.S. credit crisis, Gilani was able to provide insider insights that no other financial writer or commentator could hope to match. He drew upon the experiences and network of contacts that he developed through the years to provide Money Morning readers with the "real story" of the credit crisis – and to propose an alternate plan of action. It's a perspective on the near-financial meltdown that more than 140,000 readers have already read – and an insight that you'll find nowhere else.

If you missed Gilani's investigative series, Part I appeared Sept. 18, Part II ran Sept. 22 and Part III was published Sept. 24. Gilani's plan was published on Sept. 25 as an open letter to U.S. Treasury Secretary Henry M. "Hank" Paulson Jr. It actually contains contact information for readers who still wish to protest the government's action with the bailout bill by passing their disenchantment along to their elected representatives in each state's governor's mansion, and in both the House and the Senate. Check out Gilani's plan of action.

With the U.S. financial markets in such disarray, Money Morning is looking for profit opportunities beyond U.S. borders: For instance, just check out this new report on a Wisconsin-based company we've discovered that's posting quarter after quarter of earnings surprises – while the rest of Wall Street tanks. Not only does this company have a lock on China – the fastest-growing market on the planet – this corporate gem is also riding the profit wave of the most-powerful global trend that we're following right now. If you act on this opportunity now – as an added bonus – you'll also receive a free copy of CNBC analyst Peter D. Schiff's New York Times best-seller, "Crash Proof: How to Profit from the Coming Economic Collapse."]

News and Related Story Links:

• Money Morning Special Investigation of the Credit Crisis (Part I):
  The Real Reason for the Global Financial Crisis…the Story No One's Talking About.

• Money Morning Special Investigation of the Credit Crisis (Part II):
  The Credit Crisis and the Real Story Behind the Collapse of AIG.
• Money Morning Special Investigation of the U.S. Credit Crisis (Part III):
  How Complex Securities, Wall Street Protectionism and Myopic Regulation Caused a Near-Meltdown of the U.S. Banking System.

• Money Morning Special Report: How to Fix the Credit Crisis (Part IV):
  Dear Hank: Here's How to End the Credit Crisis at No Cost to Taxpayers.

• Money Morning Special Investigation of the U.S. Credit Crisis (Part V):
  Heads They Win, Tails You Lose: Why the Bailout Plan Will Fail U.S. Taxpayers.

• Money Morning Special Investigation of the U.S. Credit Crisis (Part VI):
  Credit Crisis Update: An Inside Look at the Commercial Paper Debacle

• Wikipedia:
  Federal Funds Rate.

• Money Morning Market Analysis:
  By Relaxing "Mark-to-Market" Rules, Has the U.S. Switched Off its Financial Crisis Early Warning System?

• AllExperts.com:
  Using Banks and Bank Accounts; Cost of Funds.

• Wikipedia:
  Mortgage-Backed Securities.

• Wikipedia:
  Commercial Paper.

• NASA History:
  Apollo 13: "Houston, We Have a Problem."

• Reuters Financial Terms Glossary:
  Matched Book.

• Wikipedia:
  Discount Window.

• Wikipedia:
  Term Auction Facility.

• Wikipedia:
  Federal Deposit Insurance Corp.

• Money Morning News:
  Federal Reserve to Buy Commercial Paper to Free Up Frozen Market.

• Wikipedia:
  Federal Open Market Committee.

• McClatchy Newspapers:
  Fed's half-point rate cut proves no match for Wall Street's fear.

Shah Gilani

About the Author

Browse Shah's articles | View Shah's research services

Shah Gilani is Chief Financial Strategist for Money Map Press and boasts a financial pedigree unlike any other. He ran his first hedge fund in 1982 from his seat on the floor of the Chicago Board Options Exchange. When options on the Standard & Poor's 100 began trading on March 11, 1983, Shah worked in "the pit" as a market maker. He helped develop what has become known as the Volatility Index (VIX) - to this day one of the most widely used indicators worldwide. After leaving Chicago to run the futures and options division of the British banking giant Lloyd's TSB, Shah moved up to Roosevelt & Cross Inc., an old-line New York boutique firm. There he originated and ran a packaged fixed-income trading desk and established that company's "listed" and OTC trading desks. Shah founded a second hedge fund in 1999, which he ran until 2003. Shah's vast network of contacts includes the biggest players on Wall Street and in international finance. These contacts give him the real story - when others only get what the investment banks want them to see. On top of the free newsletter, as editor of The 10X Trader, Money Map Report and Straight Line Profits, Shah presents his legion of subscribers with the chance to earn ten times their money on trade after trade using a little-known strategy. Shah is a frequent guest on CNBC, Forbes, and MarketWatch, and you can catch him every week on FOX Business' "Varney & Co."

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