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Fed Rate Cut, Credit Market Turmoil
9/30/2007
Fed Rate Cut by Half Percentage Point
On Sept. 18 of 2007, Federal Reserve cut fed fund rate by half
percentage point while most experts were expecting only a quarter
percentage point rate cut.
This larger than expected rate cut was significant image change of Fed
Chairman Ben Bernanke. Fed Chairman Bernanke was considered more
cautious and less willing to cut interest rate to save the credit
market previously. After all, this larger than expected interest
rate cut demonstrated that Fed is determined to prevent
the credit market crisis from
spilling over into general economy.
This significant event was exactly the play book we expected since
summer of 2007. We expected that credit market
would recover and Fed would not let the system fail. Here we go,
the Fed stepped in a major way to save the system.
How can Fed Rate Cut Help Credit Market?
Confidence Boost
The Fed rate cut boosted market confidence significantly. At
height of credit crisis in August, the bond market virtually was closed
and investors were unwilling to buy new bond offering. After the
rate cut, First Data Corp (former ticker: FDC)
$24 billion buyout deal was closed on Monday last week. Further more,
words leaked out that First Data Corp $5 billion loans out of $13
billion total were successfully offered to investors and investors'
demand for the loans outstripped the supply.
Profitability Boost for Banks
In addition, the Fed rate cut would significantly help the bottom line
of banks and financial firms.
Banks typically do not want to hold the loans on their balance sheet
and would prefer to sell loans into credit market immediately
after buyout deal closing. In case banks can not sell the loans
to investors, banks would have to hold the loans on their books.
Banks make money on loans in their books mainly by borrowing short term
money
from Feds or other sources, and lending out money on long term loans.
Table 1 shows the profitability change on a hypothetical $1
billion loan. As shown in table 1, banks' net
profit on the hypothetical loan increased 25% after the
0.5% rate cut.
Table 1 - Profitability
Change
on a hypothetical $1 billion loan
0.5% rate cut, short term interest rate change: 5% -> 4.5%
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Before
Rate Cut
(5% rate on cost)
|
After
Rate Cut
(4.5% rate on cost)
|
Interest
Income (7% loan)
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$70 million
|
$70 million
|
Short
Term Borrowing Cost
|
$50 million
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$45 million
|
Pre-tax
Net Income
|
$20 million
|
$25 million, + 25%
|
Currently, US economy is still very sound and the default rate on
corporate loans is low across the board. Therefore, when the
profitability of holding on loans is increasing
25% after rate cut as shown in table 1, banks would be more willing to
hold the loans until maturity or until the credit market recovers.
First Data Corp Case
First Data Corp buyout
deal
closing was first major indication of credit market improvement.
First Data Corp $13 billion loans were offered at
deep discount of 96 cents on a dollar. In other word, the banks
are selling at 4% loss on the loans after
closing. lenders typically earn 2% commission on buyout deals so that
the real net loss for banks would be only 2% adding back the merger
commission profit.
Conclusion on Credit Market
In conclusion, credit market improved significantly after Fed rate cut.
Under current condition, lenders are still expected to lose a
low single digit percentage on their existing bond deals if lenders
choose to sell the loans directly into credit market.
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