The problems of the credit market in the US in a nutshell

The value of mortgage-backed securities are falling due to the default by subprime borrowers. The banks who own the bulk of these securities have to write-down the value of the securities. The losses from these write-downs are making big impacts their balance sheets. Their capital bases smaller because the losses are eating into shareholders' funds. For that reason, they have a lower ability to lend out money to consumers. This pushes up the prime rate (the equivalent of Bank Lending Rate (BLR) in Malaysia). The economy then becomes stagnant as firms postpone their capital expenditure. This leads to recession, which result in a higher unemployment, lower consumption by consumers and lower capital expenditure by firms.

So, the Fed decided to intervene in the market by providing cheap money. First, they lowered the Fed Funds rate (they have done this 5 times since September 8). The Fed Funds rate is basically the rate all banks lends to each other. By lowering the Fed Funds rate, they hope that the banks can provide more credit (i.e. lend more money) to the consumers, thus averting recession.

However, the Fed realised that the market is not reacting as much as they expected. Hence, last Friday they provided a new line of credit for the banks and big financial institutions. $200 billion cash loans were released to the banks. They hoped that this move would ease the credit shortage in the market, but it did not. Wall Street did not react much. In fact, the Dow Jones Index, the bellwether of US economy, fell heavily.

Finally yesterday, the Fed provided a new initiative. They offered to lend the banks up to $200 billion of Treasury securities (the most secured type of security available in the market) in exchange for mortgage-backed securities as collateral. Effectively, the Fed are taking the mortgage-backed securities off the hands of the banks, keep them in storage somewhere until their values are restored, while giving the banks the chance to strengthen their balance sheet.

Early response from the market shows that this measure is working. Dow Jones Index had its biggest one-day hike in five years on Tuesday. The Dow Jones Index might fall again in the near term, but Fed has stated their intention to provide more liquidity to the market, if necessary.

Here is an article from the New York Times regarding the latest move from the Fed. Enjoy!