Fed, Wall Street are playing chicken

And interest-rate cuts might help Wall Street, especially the big banks, avoid the biggest problem: a shortage of capital. Every time a Wall Street financial company takes a write-down on securities backed by mortgages or buyout loans, it takes a hit to its capital.

Every time a bank has to take one of the off-balance-sheet structured investment vehicles (SIVs) onto its balance sheet because the SIV is in trouble, it takes a hit to capital. (Banks funded SIVs to invest in asset-backed paper.) The new investments on the bank's balance sheet pump up its total assets, and even if capital levels remain the same, capital sinks as a percentage of the new, larger total.

If the problem gets bad enough, as it did at Citigroup (C, news, msgs) recently, capital can fall below the levels the bank has promised investors and regulators.

At Citigroup, all of the losses pushed the bank's tier-one capital ratio down to 7.3%. That was below the company's target of 7.5%. Investors in the company's stock got nervous as they began to imagine that the bank might cut its dividend payout to preserve capital. That's one of the reasons behind the stock's dive from $47.14 on Oct. 8 to $29.80 on Nov. 27 -- a drop of 37%.

Citigroup's conundrum

In any event, Citigroup found an investor, the Abu Dhabi Investment Authority, that was willing to put up $7.5 billion (yep, that's "billion," with a B) in new capital. But if you look at the cost of the deal, you'll understand why Wall Street really, really doesn't want to go down this road. The investment takes the form of mandatory convertible securities. These convert to Citigroup common stock at $31.83 to $37.24 a share over the next two to four years. And in the meantime, Citigroup will pay out 11% interest. That's expensive money.

And there's no guarantee that Citigroup won't have to go back to investors for more capital. Even this infusion, as big as it sounds, is enough to raise Citigroup's capital ratio only about half a percentage point. That brings the bank's capital ratio above its 7.5% target -- at least until the next round of write-offs or the moment when Citigroup has to take off-balance-sheet debt onto its books.

Of course, Wall Street can't come right out and say it wants an interest-rate cut to save its balance sheets. That would be too naked a bailout even for these times, when almost anything goes. And the Federal Reserve would never be able to defend a rate cut made on that logic. To do so would shred the credibility of Bernanke's bank, and credibility is a central bank's most valuable asset.

Enter the R-word

So instead, Wall Street is arguing that if the Fed doesn't cut interest rates, recession looms. The Fed doesn't seem to find that very convincing, if the enhanced economic forecast and the minutes of the Oct. 31 meeting of the Open Market Committee are good indicators.

But that's not the only argument in Wall Street's arsenal. There's also: "We need a rate cut because the financial markets are in danger of seizing up."

That they certainly are. Banks are hoarding cash so they don't have to go to the financial markets to raise capital at 11%, as Citigroup has done. Demand for asset-backed commercial paper, the short-term debt that funds everything from company operations to SIVs, has dropped off a cliff again. The volume of asset-backed commercial paper outstanding dropped by almost $30 billion in the first week of November, according to the Federal Reserve. That's the biggest drop since the debt-market collapse in August.

• Talk back: Should the Fed cut interest rates again?

A drop in asset-backed commercial paper outstanding means that companies that would have rolled over $30 billion in maturing short-term debt couldn't find takers for their paper and had to find some other source of money. That's tough when banks, the major alternative source of short-term capital, are hoarding cash.

The dash for more cash

The Federal Reserve just isn't buying Wall Street's argument that the way to solve the debt-market crunch is to lower interest rates -- at least not yet. The Fed has decided to try to fix the crunch by putting more cash into the financial system directly. Normally, the Fed makes extra cash available to banks through overnight loans.

But in response to the crisis, Bernanke's bank has announced "overnight" loans that won't come due until Jan. 10. An infusion of cash -- $8 billion -- on Wednesday carried that extended deadline, and the Fed has said it will make other cash infusions with similar terms.

The hope is that with this longer-term cash available, banks will become more comfortable about lending to each other because they won't fear getting caught short of cash themselves if a borrower has to delay repayment. The Fed's cash infusions with shorter time limits haven't fixed this problem. Banks remain nervous about lending to other banks the reserves they keep overnight with the Federal Reserve. Recently, interest rates on those overnight interbank loans have carried a rate premium about seven to eight times above normal.

The question is how long the Federal Reserve will be willing to wait to see if its liquidity infusions unfreeze the debt markets and how long it will wait to see if the three recent rate cuts bump up economic growth.

Wall Street is betting that the Fed will panic again before the end of the year. That would make Wall Street the winner of this round of chicken, too.

Continued: Developments on a past column

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