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The week of November 25, 2007 may go down in history as the week that the Federal Reserve did the seemingly impossible...

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How the Fed Pulled the Rabbit out of the Hat

The week of November 25, 2007 may go down in history as the week that the Federal Reserve did the seemingly impossible…

The week of November 25, 2007 may go down in history as the week that the Federal Reserve did the seemingly impossible: stabilize the black hole which is the sub-prime meltdown, halt the continual erosion of the dollar versus the Euro, Pound and Yen, encourage overseas investors to come pouring back into the bargain dollar investment market, decimate the inflation rate, knock down the gold price, drive the DOW up over 500 points in 2 days, and push the Republicans up in the online Zogby Poll to beat  Hillary Clinton.

Okay, so maybe the Fed wasn’t responsible for all of the above.  But the bottom line remains that, suddenly, the financial world seems to be looking a lot better.  While some would argue that this is a sucker’s market (and they may still be correct), the truth is that the Fed did some pretty tricky things a few months ago that appear to be beginning to bear fruit. 

The most important tweak was barely covered by the financial press and not at all by the major national newspapers.  I was first tipped off to this by Dr. Gary North.

On August 17, the Fed published a change to its regulations “clarifying” the overnight borrowing of funds from the Fed by the nation’s major banks, the so-called “repo” or repurchase agreements.  The Fed now allows for “a broad range of collateral”.   

The Fed specifically said:  “The Reserve Banks accept performing mortgages.  This could include sub-prime mortgages.” 

Wow! 

The Federal Reserve decided to allow the banks to present as security to the Fed the banks’ doggy portfolio of sub-prime loans — worthless in the open market — and treat them as if they worth fully 100% of their face value, not their market value.  Moreover, the Fed allowed the banks to maintain these loans not just for a day or two but “for as long as 30 days, renewable by the borrower”.

In other words, the Fed became the absolute backer of last resort and through the overnight Fed borrowing window and its bank-only rate — which the Fed also dramatically cut to make the loans easier to make — the Fed instantly poured massive liquidity into the market. 

Poof. 

By telling the banking world that it would bail it out short term, no matter what, the Fed once again has acted as the bank of last resort.  Throwing out all the noise about creating a moral hazard  in so doing, the Fed has a responsibility to make its fiat money acceptable in the marketplace.  Period.  Of course there was a moral hazard failure.  And we’re not surprised.

The giant US money center banks once again have learned that they ultimately can count on the Fed to bail them out when they get into trouble.  Little banks will go bankrupt or be forced to merge into larger banks (look for this to happen with E-Trade soon).  Even big banks may be forced to make their top management fall on their swords. In November, both the Chairmen & CEO’s of  Merrill,Lynch and CitiCorp — America’s largest investment bank and retail bank, respectively — were fired.  But the banks themselves are going to survive, no matter what. 

When Richard Nixon finally yanked the US off the gold standard back on August 15, 1971, there was nothing else left except “the full faith and credit” of the federal government to back up the greenback.  So whether the people have confident in their government matters a lot more when it completely controls their money supply in a monopoly-based banking system.

Compare the Fed’s actions with that of the poor old Bank of England. 

The UK’s own sub-prime meltdown occurred this summer when Northern Rock (the UK’s equivalent of America’s Countrywide Home Loan Bank) had a run on the bank.  Consumers heard that Northern Rock’s loans were going bad and that their might not be enough money in their coffers to pay back the depositors.  Of course this is how modern banking works: borrow short-term and lend long-term.  All depositors’ money is at risk when most banks today are allowed to lend out upwards of 20 times the money they have on deposit in their ‘reserve’ account with the central bank.  This ain’t Switzerland in the 1930’s. 

But when Northern Rock went to the Bank of England to bail it out with a short-term loan to stem the flow of frightened depositors literally waiting on their door steps, the BofE turned them down.  The result was a mini-crisis which morphed into a major crisis and ultimately saw the BofE belatedly pouring over $50 billion into Northern Rock and allowing the damage to spread to the major high street banks like Barclays.

Although the Bank of England is an old hand at issuing and manipulating its fiat currency, the world’s master at this game is the Federal Reserve.  And the Fed has been able to successfully export its fiat currency (the dollar) and its inflationary policies globally, to the (temporary?) direct benefit of the US consumer.

Meanwhile, it’s estimated that the European Central Bank has had to pour over $200 billion into its banking system to bail out the German, French and other Euro-based banks which, strangely, have been investing enormous sums of Euros to buy US sub-prime real estate securitized loans instead of investing in their own home ownership or business development programs.

And on November 26, England’s HSBC, one of the top-10 world banks, announced that it was biting the bullet on its own sub-prime portfolio disaster and moving more than $35 billion dollars back onto its own books from funds that it was managing to prevent a forced liquidation at fire sale prices of what it called “high-quality assets”.  This is probably not a good time to own overseas bank stocks.

Score:  Fed 1, World Banks 0.  8 innings — at least — to go.

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Mr. Easton teaches University economics and is passionate about technology and entrepreneurship. He is rosy about the long-term future: ‚??The glass isn‚??t half full, it‚??s overflowing!‚?Ě

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