The Fed's over night discount rate cut of Friday has a lot of people wondering; "What is going on?" and "Why it was done?" I could be shot again for over simplification on this one. On the plus side, there are no complicated graphs, so read on.
Imagine a bunch of little stores that are about to open in the morning. Before they open, they go to the cash register and put in their transaction money for the day. This would be something like 5 20’s, 10 10’s, 20 5’s and 40 1’s and quarters, dimes nickels and pennies. This money is needed to open the store. The bigger the store, the more transaction money is needed.
Now let’s go one step further. Suppose the money is not there to open the store. Most businesses have an open credit line with their bank for such occasions. They can go down and borrow the money. What the heck, at the close of business, they can pay it back.
On to step three, the banks issue these lines of credit to businesses thinking that maybe only five to ten percent of their clients will call for such a loan at any one time. They were not counting on all of their clients lining up at the credit line window at the same time. The bank at this point has over contracted these lines of credit, and has to go to the Fed window for an overnight loan. Wasn’t it Countrywide that exercised their line of credit for 11.5 billion Thursday with 41 lenders?
So what is happening? New money is not flowing into the system. People are not borrowing, buying or what ever. The money supply is contracting. Lowering the discount rate, allows banks to make those loans to business so they can open with cash in the drawer ready for business. It’s no longer an over-nighter, hey pay us when you can. I think the Fed is stealing the same boiler plate previously used on home loans.
But why did the stock market go up? The increased access to liquidity allows the big traders to exercise their credit lines. After all buying and selling stocks is a business. You’ll notice that Bernanke picked an expiration Friday, (before the market opened) to drop the discount rate, which burned the short option players royally. Done like a true professional!
Halloween is early this year, the third Friday (Thursday if you're smart) in September, a Triple Witching Expiration. I guess I’ll mosey over for some cider and donuts at the 11.5 billion dollar bon(d)fire.