Connecting Fed cuts with credit writedowns and quantitative easing

To my mind, lowering interest rates in the aftermath of an enormous credit bubble where institutions have just destroyed $1 trillion in capital is wrong. It distorts lending decisions such that yet more money will eventually be lent out imprudently. The only way to increase credit availability is by getting reserves into the system. And normally you do that by making a profit. However, profits are hard to come by for financial institutions right now.

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This is a thought experiment.

Imagine it’s the year 2003 and I am a senior credit card company executive. I have grown bored with my job and want to venture out on my own and start up a new company. With my industry connections, I am able to raise 400 million in capital. I soon start ABCD Card Financial and we are ready to start issuing cards.

Now, it just so happens, I am a fairly prudent fellow and I lend cautiously to creditworthy borrowers. But, unbeknownst to me, ABCD’s CFO invests our hard earned capital in Credit Card Asset-Backed Securities. Mind you, this is AAA-rated stuff, so to most observers, this looks like a prudent use of money.

Anyway, business goes well and we take the company public in 2006, raising $1.4 billion for 65% of the company. That’s a nice return for three years work. We are now flush with capital, $2 billion worth including retained earnings. We leverage this up 20 times committing to $40 billion in loans. Much of the capital is invested in more Asset Backed Securities.

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Fast forward to 2009. We are now experiencing a deep recession and people are defaulting left and right on their credit cards. Suddenly, those AAA Asset-Backed Securities aren’t looking like a good call after all. ABCD is forced to announce credit writedowns of $300 million. But, luckily for us, our overall lending has been prudent and while charge-offs are high we will survive.

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Now, think about it for a second. We just wrote off $300 million of capital. That means we have $6 billion less to lend. So everything else being equal, this credit writedown just vaporized $6 billion. Poof, gone.

What’s my point? Well, globally, financial institutions have written down almost $1 trillion. That is an enormous amount of credit that vanished in the stroke of a pen. Do you think that lowering interest rates 75 basis points more to 0.25% as the Federal Reserve did today is going to get ABCD to lend as much as it did before the writedowns? Maybe, if only we can leverage to 30 times capital and lend to riskier borrowers and that is not in our best interest.

When the Fed lowered interest rates to 0.25% today, the lowest since record keeping began in 1954, it influenced the price of credit lower, but not necessarily the quantity of credit. Low interest rates — what I call easy money — are not going to get the job done. What financial institutions need is more reserves and more capital.

So, what if the Fed came to my CFO and said we’ll trade you some of the Treasurys you own in your short-term investments for dollars? For the right price, we would say yes. Where do the dollars come from? Out of thin air of course. The Fed creates them in order to buy my assets. This is called quantitative easing. It’s basically inflating the money supply plain and simple. The difference between quantitative easing and low interest rates is that easing actually increases my reserves, giving me more money to lend. Whether I choose to lend is another question.

To my mind, lowering interest rates in the aftermath of an enormous credit bubble where institutions have just destroyed $1 trillion in capital is wrong. It distorts lending decisions such that yet more money will eventually be lent out imprudently. The only way to increase credit availability is by getting reserves into the system. And normally you do that by making a profit. However, profits are hard to come by for financial institutions right now. So the Fed can step into the breach adding reserves by purchasing assets with money that the central banks creates. Mind you, this is inflation. Even so, this money inflation won’t necessarily get financial institutions to increase lending.

On the other hand, lowering interest rates just won’t work.

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