Fear and Greed and the Federal Reserve Board

Oh My! When last we looked, the score was Fed 1, Crash 0. That was way back in 2007. A lifetime ago if you’re a day-trader.  

Greed in the street has now turned into rank fear. And the contrarian investor argues that when everyone is fearful, well that’s the perfect time to jump back in to make a killing. So, greed is good. Got that?

In the good old days (say, last October), hope was still blossoming along with the weeds of the sub-prime meltdown mess. Most economists were predicting that the US would squeak through 2008 with slow growth – and just miss going into a recession. The Fed had taken action back on August 17th to allow banks to pony up to the Fed window and hand in sub-prime mortgages at full face value in return for 100% cash in-the-bank Fed money. Several hundred billion dollars in dodgy assets appear to have been handed over to the Fed at the time.

Then, during the week of November 25, 2007, the Federal Reserve Board, acting in coordination with the Bank of England and the European Central Bank (among others), dumped several more hundreds of billions of dollars in liquidity into the marketplace through the creation of new embarrassment-free lending vehicles for the money-center banks (read: Citicorp, et. al.). When all the world’s central banks were counted, the total new “loans” provided to the banks exceeded $1 trillion. Now that’s beginning to be real money.

Next, on Tuesday, March 11th, the Fed injected another $200 billion into the banking system via weekly auctions where it will lend treasury bills for 28-day periods in return for debt, including “AAA-rated mortgage securities” sold by Fannie Mae and Freddie Mac, and by banks. Loans will be made under a new program called the “Term Securities Lending Facility,” to the 20 banks and securities firms that trade directly with the Fed.

This is uncharted water. As Nick Parsons, head of strategy at NAB Capital, said to the UK’s Guardian Newspaper: "The Fed is digging a firebreak. The fire was threatening to engulf good assets, bad assets, every sort of asset.” It may yet still.

All was calm for another 5 days. Above the surface.

Finally, on Sunday, March 16th, at the start of Easter Holy Week, the Federal Reserve next did the previously unthinkable: it opened up yet another lending “window” at the New York Fed (where do they find the workmen to jackhammer out all these new windows late on a Sunday night?).  

This time it was for the major (20 or so) participants in the securitization markets, the New York-based “primary dealers” in things like the US Treasury Notes, to the tune of another (at least) $200 billion. This includes Merrill Lynch, Goldman Sachs — and Bear Stearns, the 5th largest “investment banker” in the US.  Notice that these are stock brokers, not banks.  The new window is called the “Primary Dealer Credit Facility.”  

So, for the first time ever, the Fed has opened its coffers to non-banks. Pundits have asked, “What next, Starbucks and Home Depot?” Perhaps. If it’s necessary.

The function of the Federal Reserve System is to keep the money supply stable and the financial monetary system working. Of late, the machinery has been showing a slight tendency to lock up at inopportune times and the Fed’s liberal squirts of liquid assets are being made to insure the system continues to be well if not over oiled.  

One minor problem did creep up at the same time: the imminent collapse of Bear Stearns, worth over $15 billion on Friday and perhaps a negative $30 billion on Monday morning – if it were forced to file for bankruptcy. The Fed “invited” Bear Stearns and J.P. Morgan, its next-door neighbor in lower Manhattan, to come to an “agreement” whereby JP Morgan would buy Bear Stearns, lock, stock, and new $1.5 billion headquarters building for a piddling $2 per share, or $236 million. As a good will gesture, the Fed threw in a guarantee to JP Morgan to absorb up to $30 billion of doggy assets (more sub-prime mortgages?) owned by Bear Stearns. For its part, J.P. Morgan also set aside a few billion  dollars more of its own money just in case.

Finally, to make it worthwhile for the non-banks to turn in their junk collateral to the New York Fed at the new PDCF Window down the street, the Fed dropped its interest rates for the non-banks ¼ point to 3 ¼ %.  

When the next regularly-scheduled interest rate board meeting was held on Tuesday, March 18th, Chairman Ben Bernanke and his colleagues further cut the federal funds rate (the interest that banks charge one other) to 2.25 percent, its lowest point since late 2004.
Now we’re talking! In response, the stock markets in the US and abroad duly shot up. Although a predictable  retrenchment occurred the next day, by the end of Holy Week, the stock markets had recovered, gold had dropped substantially, and even the dollar had firmed up viz-a-viz the Euro and Pound. Holders of Adjustable Rate Mortgages (or ARMS) which are having their rates reset later this year or next can now sigh with relief as they’ve been given a reprieve of another year or two of cheap interest rates.

Ben Bernanke did his Ph.D. thesis on the Great Depression, and on just what the Fed did wrong in those days – and what the Fed must do in the future to make sure that a great depression will never happen again. Basically, this involves shoveling out of bank windows or helicopter doors potloads of dollars (liquidity) to make sure that we will never have too little money to go around again. Unfortunately, this tactic is also called (at least in the old-fashioned Austrian school of economics) inflation.

The real threat to the system, however, is not the sub-prime toxic waste mortgages being held in the coffers of the investment banks, retirement funds and insurance companies. The Fed can simply buy up all of these if it has to. Jimmy Carter-like inflation of 20% will appear — but only for a few years at most.  

The real threat to the system is the $4-10 trillion (yes, trillion!) dollars worth of CDO’s: collateralized debt obligations that the global money system holds. Created as insurance to allow a bond holder to separate the “guaranteed” interest income from the “risky” fluctuating bond selling price, they have seemed to lower these risks until now. The system fails, of course, if the insurer — the other party to the CDO transaction (like a Bear Stearns) goes belly up. Not to mention that the so-called bond-rating agencies have been rating ZZZ bonds as AAA.  

The system itself must not be allowed to lock up. If Bear Stearns went down it would take lots of depositors and cross-transaction parties with it. This could have generated the feared settlement system’s doomsday scenario: cascading cross defaults, where, like dominoes, bank A fails knocking down its correspondent bank B which tips over bank C and so on. Along with every person and every business holding assets in those banks.

By its actions over last weekend, the Fed stopped the eminent crash from happening. Hats of to the Fed. Really. Bless you Ben Bernanke.

So, bottom line, the score appears to now be: Fed 2, Crash 1, with lots of innings yet to go. As someone who is perhaps irrationally optimistic, I personally believe that he has an excellent chance of pulling it off. We’ll see.

Meanwhile, if you compute the real GDP of the US on a per-capita adjusted basis (divide the GDP by the population), we seem to have drifted into a recession since mid-November. But in GDP-only terms, we’re still in positive territory. And a recession, by definition, is 2 quarters (6 months) of continuously falling GDP.

Of course all of this was predicted by Ludwig von Mises. It’s what you’d expect when you run a fiat-money system — and top it up with loads of highly leveraged debt. And we’ve been doing it for 90+ years now.


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