Federal Reserve: An Upper-Class Pawn-Shop For Well-Dressed Bankers?

Dan Denning - Wed 15 Aug, 2007

The world's central banks are bailing out the world's so-called capitalists. So you can add financial stocks to the long list of institutions that are apparently "too big to fail" in today's world. The Fed proved this new reality last Friday, when it stepped in to bail out people who failed to correctly model the risks of making or owning loans to risky borrowers. Early Friday morning in New York, the Federal Reserve stepped calmly into the fray as a buyer of last resort. A buyer of what? Mortgage-backed securities - the market that's been causing everyone so much grief.

The world's central banks are bailing out the world's
so-called capitalists. So you can add financial stocks
to the long list of institutions that are apparently
"too big to fail" in today's world. The Fed proved this
new reality last Friday, when it stepped in to bail out
people who failed to correctly model the risks of making
or owning loans to risky borrowers.

Early Friday morning in New York, the Federal Reserve
stepped calmly into the fray as a buyer of last resort.
A buyer of what? Mortgage-backed securities - the market
that's been causing everyone so much grief.

The Fed released a statement, announcing that, "The
Federal Reserve will provide liquidity to facilitate the
orderly functioning of financial markets....In current
circumstances, depository institutions may experience
unusual funding needs because of dislocations in money
and credit markets. As always, the discount window is
available as a source of funding."

On the surface, the Fed's action seemed to reassure
investors. It "injected" US$38 billion in cash into the
financial system, accepting mortgage-backed bonds as
collateral from institutions that were having trouble
borrowing from the usual sources. In other words, the
Fed accepted the toxic mortgage-related debt that no one
else in the world wants to touch, and loaned out cash
against that collateral. It literally brought liquidity
to a market which had basically stopped trading.
Think of it as an upper-class pawn-shop for well-
dressed bankers.

You could almost hear the collective exhale of relief
from Wall Street, as the market dodged another red day
full of distressed selling. A lot of people who needed a
drink probably had one. Or two.

In Latin, delirium tremens means "trembling madness."
The dictionary defines it this way, "A serious alcohol-
withdrawal syndrome observed in persons who stop
drinking alcohol following continuous and heavy
consumption. It involves profound confusion,
hallucinations, and severe nervous system over-activity,
typically beginning between 48 and 96 hours after the
last drink."

The Fed has given the market a stiff drink to off-set
the symptoms of credit withdrawal. As any good drunk
will tell you, a drunk is always a drunk, even if he
stops drinking. There is no cure for addiction, just a
replacement of bad habits with better habits. Below the
surface, what exactly has the Fed done and what does it
mean for the weeks ahead?

The unusual aspect of the Fed's actions last week was
its willingness to accept mortgage-backed collateral for
its short-term lending. In three separate operations,
the Fed added US$19, US$16, and US$3 billion in cash to
the market through its open market operations. When it
loans money for short periods of time, the Fed usually
accepts either US Treasury bonds or government agency
securities (Fannie Mae and Freddie Mac bonds) as
collateral.

The fact that it went out of its way to accept mortgage-
backed bonds as collateral shows you what the real
intention of the Fed's actions was: to avert more panic
selling and liquidation of mortgage-backed securities,
especially by traumatised hedge funds. Even though the
Fed bought the market a reprieve, it didn't solve the
fundamental problem facing the US$2 trillion
subprime market.

No one really knows what all these mortgage bonds - and
mortgage derivatives - are worth, because there aren't
any buyers (although that might give us a hint of what
the market really thinks the bonds are worth). It is one
thing for the Fed to accept them as collateral for
short-term loans. It is quite another thing for real
buyers to emerge in the market.

The Fed hasn't cleared up the fundamental problem facing
the credit markets. It has merely bought some time for
the most distressed players. Unfortunately, the Fed's
actions last Friday probably bought very little time.
The distressed owners of mortgage securities still lack
a liquid market for the formerly high-yield securities
that used to be so popular.

It will be an interesting battle between buyers and
sellers this week. Traders with nerve will be tempted to
load up on the high-yield blue chip stocks that funds
dumped last week. The funds dump blue chips to raise
cash. It's much easier to sell Citigroup, GE, or BHP
than to sell exotic financial instruments these days.
Hence the selling.

Is it time to be a blue chip buyer or is it better to be
in cash? Well that depends on how troubled the market
really is by the subprime mess. Here's the thing,
though. The sub-prime meltdown has shown us that the
whole class of exotic financial instruments that became
so popular in the last ten years are difficult to value
and even more difficult to trade. The value of the
collateral in the mortgage market, for example, has
upset the whole apple cart in the mortgage-backed bond
market. How will other asset-backed securities fare?

Markets have consistently underestimated the seriousness
of the subprime situation. It's possible that most
conventional models simply don't account for the kind of
human instincts that take over in a panic. There could
be a lot more selling, the kind that not even a central
bank can prevent.

Regards,

Dan Denning
for The Daily Reckoning 

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