Similarly, suppose a manufacturer buys $100 worth of widgets, and gives the widget maker an IOU to pay for them 30 days from today. If the widget maker sells that IOU to a bank for, say, $99 today, the note is said to be "discounted." In 30 days, the manufacturer pays the $100 to the bank to clear the obligation. Within the meaning of the Federal Reserve Act, the word "discount" is exclusively used in the context of this sort of short-term payment clearing function.
The Federal Reserve Act gives the Fed the ability to discount a wide variety of "paper." These provisions, mostly in Section 13, were put in place to guarantee short-term liquidity - again, essentially a sort of "check cashing" function. It was not intended to make long-term loans, purchase risky securities, or to provide solvency. To the contrary, there are numerous provisions to ensure that the obligations that the Fed pays off (by purchasing them at "discount") are short-term, promptly collectible, and well-collateralized.
Consider Section 13.2 (Discount of Commercial, Agricultural, and Industrial Paper). This allows any Federal Reserve bank to discount "notes, drafts, and bills of exchange arising out of actual commercial transactions; that is, notes, drafts, and bills of exchange issued or drawn for agricultural, industrial, or commercial purposes." It also provides that "Notes, drafts, and bills admitted to discount under the terms of this paragraph must have a maturity at the time of discount of not more than 90 days , exclusive of grace." That section does give the Board of Governors the "right to determine or define the character of the paper thus eligible for discount," but only "within the meaning of this Act."
Look at other provisions, and you'll also consistently see what Congress intended by the word "discount" within the meaning of the Federal Reserve Act.
Section 13.4 (Sight Drafts): "...Provided , That all such bills of exchange shall be forwarded promptly for collection , and demand for payment shall be made with reasonable promptness after the arrival of such staples at their destination: Provided further , that no such bill shall in any event be held by or for the account of a Federal reserve bank for a period in excess of ninety days. "
Section 13.6 (Acceptances): "...which have a maturity at the time of discount of not more than 90 days' sight , exclusive of days of grace, and which are indorsed by at least one member bank: Provided , That such acceptances if drawn for an agricultural purpose and secured at the time of acceptance by warehouse receipts or other such documents conveying or securing title covering readily marketable staples"
Section 13.13 (Advances): "... secured by direct obligations of the United States or by any obligation which is a direct obligation of, or fully guaranteed as to principal and interest by, any agency of the United States. Such advances shall be made for periods not exceeding 90 days "
Section 13A (Agricultural Paper): "... Provided , That notes, drafts, and bills of exchange with maturities in excess of six months shall not be eligible as a basis for the issuance of Federal reserve notes unless secured by warehouse receipts or other such negotiable documents conveying or securing title to readily marketable staple agricultural products or by chattel mortgage upon live stock"
Section 24(b) (Real Estate Loans): "...Notes representing loans made under this section to finance the construction of residential or farm buildings and having maturities not to exceed nine months shall be eligible for discount as commercial paper within the terms of the second paragraph of section 13 of the Federal Reserve Act if accompanied by a valid and binding agreement to advance the full amount of the loan upon the completion of the building entered into by an individual, partnership, association, or corporation acceptable to the discounting bank."
The restriction that the Fed can only operate "within the meaning of this Act" is a real problem for the Fed.
Now, consider Section 13.3, which is the section that the Fed used as the justification for making outright purchases of questionable long-term mortgage securities from Bear Stearns:
Section 13.3 Discounts for Individuals, Partnerships or Corporations: In unusual and exigent circumstances, the Board of Governors of the Federal Reserve System, by the affirmative vote of not less than five members, may authorize any Federal reserve bank, during such periods as the said board may determine, at rates established in accordance with the provisions of section 14, subdivision (d), of this Act, to discount for any individual, partnership, or corporation, notes, drafts, and bills of exchange when such notes, drafts, and bills of exchange are indorsed or otherwise secured to the satisfaction of the Federal Reserve bank: Provided , That before discounting any such note, draft, or bill of exchange for an individual, partnership, or corporation the Federal reserve bank shall obtain evidence that such individual, partnership, or corporation is unable to secure adequate credit accommodations from other banking institutions. All such discounts for individuals, partnerships, or corporations shall be subject to such limitations, restrictions, and regulations as the Board of Governors of the Federal Reserve System may prescribe.
It should be obvious that the Maiden Lane arrangements didn't represent "discount" transactions under any reasonable interpretation of the Federal Reserve Act. Instead, the Fed created shell companies to stash long-term securities of questionable credit quality, bought them outright, and still holds them more than two years later. This is simply illegal.
These arguments are not about whether various financial institutions should or should not be bailed out. They are about whether we have any interest in preserving a representative democracy that operates under the rule of law; or whether we instead want a fourth branch of government that operates independently of Constitutional checks and balances, where unelected bureaucrats can arbitrarily commit a greater amount of public funds in a day than the National Institute of Health spends on public research for cancer, Alzheimers, Parkinsons, autism and other disorders in a year. Count me out.
Market Climate
As of last week, the Market Climate for stocks remained characterized by an overvalued, overbought, overbullish, rising yields conformation that has historically been hostile for stocks. As noted above, we would be likely to take a more constructive position after clearing some combination of these factors, if it was coupled with a further improvement of various leading economic measures (Philly Fed was a start, but the overall set of measures is still negative and mixed). A constructive position, given current valuations, would most likely be limited to covering a portion of our short call positions, leaving most or all of our put option defenses in place. A significant improvement in valuations, followed by a firming of market internals, would give us more latitude for larger exposures to market fluctuations. For now, both Strategic Growth and Strategic International Equity remain tightly hedged. In bonds, the Market Climate remains characterized by unfavorable yield levels and rising yield trends. Strategic Total Return remains strongly defensive, with a duration of less than one year, and only about 4% in bond market alternatives such as precious metals, foreign currencies and utility shares.
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