FED BACK TO THE VOLCKER TRADITION

Bernanke's Rate Cut Restores Volcker Tradition

AUGUST 17, 2007, MARKS THE RETURN of traditional central banking at the U.S. Federal Reserve under Chairman Ben Bernanke.

By cutting the discount rate -- and not the overnight federal-funds rate target -- the Fed has gone back to the classic function for which central banks are created: to act as lender of last resort to troubled lenders who cannot obtain funding in the market.

Under Alan Greenspan, the former Fed chairman, the primary solution to financial crises, from the October 1987 stock market crash to the 1998 Long Term Capital Markets hedge-fund blowup to the bursting of the tech-telecom bubble in 2000, was to slash the fed funds rate. That provided cheap money to the deserving and the feckless alike, and gave rise to the notion of the so-called Greenspan Put -- an insurance policy for speculators when markets went bad.

But Friday's action of lowering the discount rate a half percentage point, to 5¾% from 6¼%, adheres to the first principles of central banking going back to Walter Bagehot -- lend freely in a crisis, albeit at a penalty rate to ensure these borrowings aren't abused. The Fed's target for the fed-funds rate remains unchanged at 5¼%.

In that, the Bernanke Fed returns to the practices under Paul A. Volcker, Greenspan's predecessor and arguably the most effective chairman in the Fed's history.

In 1984, Continental Illinois faced a form of a run in that it was unable to obtain funding in the money market after buying bad loans from Penn Square Bank, an aggressive lender to the oil patch that went bust. Instead, Continental borrowed from the Fed, avoiding a systemic risk to the system. Meanwhile, as the Fed pumped reserves into Continental Illinois, it drained them from the rest of the banking system, and was able to maintain a tight overall monetary policy.

In the last week, the Fed has attempted to provide ample liquidity to the banking system, but evidently it wasn't flowing where it was needed most.

According to data released late Thursday, the Fed added $17.7 billion a day to the banking system in the week ended Wednesday through repurchase agreements. At the same time, commercial paper outstanding plunged by $81.6 billion, or about 4%, in the week ended Wednesday, according to the Fed's data before seasonal adjustment.

All the extra liquidity sluicing through the financial system mainly found its way to the safe haven of Treasury bills, which saw their rates plunge -- to below 3% for the shortest bills at one point. Meanwhile, commercial paper rates spiked sharply higher -- for borrowers able to sell their paper, which the data showed became fewer and farther between.

In other words, lenders were flush but were unwilling to loan money. And borrowers who needed to borrow were unable to do so. That, in essence, constitutes a liquidity crisis.

The clearest evidence was the need for Countrywide Financial to tap its entire $11.5 billion credit line and sharply curtail its lending mainly to mortgages that conform to the purchase standards of Fannie Mae and Freddie Mac.

Prior to that, St. Louis Fed President William Poole told Bloomberg News it would take a "calamity" for the central bank to ease policy.

When the nation's largest mortgage originator -- Countrywide made $245 billion in home loans in the first half of the year, 17.4% of the nationwide total -- is so sharply curtailed, that qualifies as a calamity for the battered housing market.

Banks and depository institutions can borrow from the Fed's discount window against a broad range of collateral, including asset-backed securities, commercial paper, mortgage-backed securities and even whole loans. Of course, there are commensurate "haircuts" -- that is, perhaps only $95 might be lent against $100 of lesser-quality collateral. Thus, borrowing from the discount window is free or even cheap money.

Nor is it available to feckless hedge funds, which would have been bailed out by the Greenspan Put.

The Bernanke Fed's actions throw a lifeline to the institutions that truly need it. And that's how central banking is supposed to wor