Discount window to toxic debt hell...

Finally, on Friday, August 16, 2007, the Federal Reserve capitulated to the unraveling of the debt markets- mortgages, commercial paper, etc.- and reduced the so-called "Fed discount rate" by 500 points to 5.75%. This is the rate the central bank charges commercial banks in direct borrowing. This rate is still another 500 points above the short-term consumer rate of 5.25%. The Fed intends this to be the case, that is the Fed is the so-called lender of last resort. It wants to make this "discount window" borrowing to be expensive for the banks.

The problem is when the Fed does what it did last Friday, it usually means that there is a hidden problem in the credit markets. When Bank of America decides to invest $2 billion in the troubled large mortgage lender, Countrywide Financial, as it did today, some interpret it as a vote of confidence, but the reality may very well be that there's a supersized risk of repricing lurking around the corner- so large in fact that BofA is worried about its own financial health, if and when Countrywide goes under. So hellish the problem of toxic hell is, that in one-day four bulge banks- BofA, Citi, Wachovia and J.P. Morgan Chase- borrowed $500 million each to cover their positions. Such expensive borrowings are often harbingers of more systemic problems.

On their way to spreading risk, the financial engineers of today, the Ponzi schemers of yesteryear, overlooked two key issues: reducing risk burden invites riskier decisions, and casting the risk net wide hides risk. The former led to the subprime toxic mess, among other stuff, and the latter is now coming back to bite the hide of bulge banks and later us, the consumers and citizens.