The Fed's House of Cards Is Crumbling

Top Line: This evening we enter a realm of surreal as the Fed colludes with JP Morgan to "reassure" the markets. The world markets are in disarray right now trying to figure out what is going on. The US Futures are down about 2.5% while the Asian markets are down about 4%-5% as we go to press.

Where do we start? You have no doubt heard the news that JP Morgan is buying an insolvent Bear Strearns for $2 a share. If that news wasn't enough for the market, the Fed has decided to add another wrinkle by lowering the discount rate nearly simultaneously. Both of these moves occurred late Sunday afternoon which gives an aire of panic to them which the markets have sensed this evening. Plus, the cut to the discount rate was a mere 25bps, not a larger number, maybe implying the Fed's unwillingness to lower as much as the market "wants" on Tuesday, the 75bps or 100bps we heard late last week.

The underlying theme seems to be the credit crisis is still prevailing. The questions still remain like, "What other players will be affected?" This thinking process is sending chills down the spines of the world stock markets this evening, with good reason. If a company like Bear Stearns, after being in business for 85 years, can be crushed inside of a week, what other bombs are going to go off before this is over? Bear Stearns (it used to be BSC) was $60 a share on Thursday afternoon and $30 on the close on Friday afternoon and tonight is being taken over for $2 a share. In January of 2007 the price was $170.

There you have the basics as we read them this evening. What does it all mean? As we mentioned above, the markets around the world are none to pleased with it so far. Maybe by morning the bulls can spin the news towards the buy side but tonight the bears are solidly in control of the futures market as well as the Asian markets.

We were a little surprised by the news, except we weren't because we know the Chairman of the Fed has his hands full with impending deflation and he is well aware of that. He told all of the world that the Fed could prevent deflation with all of the tools at its disposal so now he's got a chance to use them. We still think his efforts are futile. The tide has turned and while the Fed will try to show its "strength", the answer will remain the same because the reason for the problem has not changed.

The reason for the collapse of Bear Stearns and several hedge funds, some of which we have mentioned here over the past several months, is the sudden contraction of credit. Is the contraction due to interest rates being too high? No, it is due to the fact that less lending is being done. There are several reasons for this and we have mentioned many of them before.

Banks are less interested in loaning money to entities with poor credit. All of this talk, and some of the actions, about the mortgage problem can be used to learn part of the reason. Who wants to loan money (by buying mortgages) when home prices are dropping on top of the fact that the actions to keep homeowners in their homes by slashing their payments to these very investors.

Our position on the situation has been that the business cycle needs to be allowed to operate. By trying to stop recessions by allowing Asset Bubbles to form, the necessary risk management policies are thrown to the wind to be replaced by aggressive loans to subprime candidates as well as no doc loans to whoever wanted them.

So, even as the Fed is trying to loan more and more money to banks and now Non-Banks, these entities don't really want to be lending it out except to very credit worthy entities. We read a great analogy in the Wall Street Journal last week that we wanted to share. You have heard us or someone talk about the Fed pushing on a string. What that means is they have a much easier job when it comes to Stopping a surging economy or maybe we should say slowing the economy by increasing interest rates. But, when they are trying to stimulate the economy by lowering rates, there is no assurances that the necessary expansionary credit will actually happen because either no one wants to borrow or the banks don't want to lend.

Anyway, getting back to the analogy we read in the WSJ, it was in an op-ed piece entitled "Recession is Ineveitable". We reprint one paragraph for you to read. We include the link so those of you with access can read the entire article which we highly recommend since we concur with the author: "The Fed is like King Canute with a difference -- it is trying to halt an ebbing tide rather than a rising one. Its liquidity injection seems huge at $200 billion (with perhaps more to follow), but it is still only equivalent to one-third of the expected losses in the NDFI sector."

We title our post this evening to try to give the picture of the Chairman of the Fed trying to keep the house of cards from falling down. He has a difficult job, we would say impossible at this point, and the impotence of the Fed will soon become a vivid image as time after time, their efforts will not be at all effective. They may never run out of money but the house of cards needs more credit creation to stay up and that is just not going to happen even with a lot of Fed money.

Your comments would be appreciated by all who stop by.

FSI: 71.32 (Monday should be interesting in the Fo(u)r Speculaton Index)