With equities likely to bounce back sharply on short covering on Monday and with all eyes on the US market for direction, the US Federal Reserve’s actions deserve close attention.

There were two important details in the Fed’s statement on Friday announcing the cut in the discount rate. One of them was that mortgage-backed securities, including unimpaired subprime securities, would be accepted as collateral for the loans from the Fed. The second was that the period of such loans had been extended from overnight to 30 days.

The move allows the banks to get funds against mortgage-backed securities, the market for which had dried up. So, if a bank were to provide funds to a mortgage lender in trouble such as Countrywide Financial Corp., it will be able to refinance the loan. True, the loan to the Fed will have to be repaid after 30 days, but that gives housing finance companies breathing space. Countrywide is already being bailed out by the banks and the Fed is signalling it is ready to stand behind such bailouts.

The Fed discount rate is higher than the Fed funds rate, which is the targeted market rate for overnight loans, so it doesn’t make much sense for banks to borrow from the discount window. But a cut in the discount rate is a powerful signal, because the markets believe it’s a precursor to a cut in the Fed funds rate.

The hope is that a rate cut will help all those borrowers who had taken out adjustable rate mortgages, or ARMs, which have a low initial rate and whose rates are reset at higher levels after a period. The data show that there will be a jump in such resets from September onwards, raising the probability of increasing defaults. A Fed rate cut will lower the interest burden.

However, observers have pointed out that the effective rate for overnight funds in the US money market is well below the targeted Fed funds rate of 5.25% and they’ve called this a “stealth rate cut." That raises the question whether this is a liquidity crisis at all, because if banks were short of liquidity the overnight rate would have been higher. The problem is one of liquidity for mortgage-backed securities and their derivatives. The Fed’s aim is to ensure that credit for good quality paper does not dry up and to give the credit markets time to work out repayment strategies for their impaired loans.

But, so far, injections of liquidity have had little effect on mortgage rates. And even after Friday’s rally, risk premiums remain at their highest in more than four years. Moreover, even if the Fed succeeds in reassuring the credit markets, it’s unlikely that banks will start creating new mortgage-backed derivatives or lend-to-hedge funds or for leveraged buyouts with the same abandon. That will mean lower liquidity for time to come. Markets, of course, are hoping for a rerun of September 1998, when the Federal Reserve organized a bailout of hedge fund Long Term Capital Management, which, together with a series of rate cuts, led to a huge rally in the Dow, which went up 44% in the next seven months, before going on to the spectacular highs of the tech boom and the equally spectacular collapse. But the trouble with history repeating itself, as Karl Marx pointed out long ago, is that “it repeats itself first as tragedy, then as farce."

Credit-deposit ratio

Back home, the credit-deposit ratio has gone below 70 for the first time in over a year. A huge surge in deposits for the fortnight ended 3 August, the latest date for which Reserve Bank of India data are available, led to the credit-deposit ratio going down to 69.71. The growth in bank credit continues to decelerate. However, growth in credit this fiscal year is finally into positive territory. Non-food credit growth is up Rs6,388 crore this fiscal to 3 August, compared with a growth of Rs61,981 crore over the same period last fiscal.

The high level of liquidity in the banking system will cushion the fallout from the withdrawal of funds by foreign institutional investors. That’s the reason why, although the rupee has been hit by the turbulence in the equity markets, the bond markets, relatively insulated from foreign participation, have been affected only marginally. Local, rather than international, factors have been responsible for the slight rise in yields. Nevertheless, it’s likely that the credit-deposit ratio has reached its nadir and will edge up in the next few weeks. That’s because the liquidity from RBI’s purchases of foreign exchange will be unavailable in future—the week to 10 August saw lower forex reserves. And secondly, non-food credit is picking up and the restrictions on external commercial borrowings will aid that process.

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