Tuesday, March 11, 2008

Helicopter Ben Is At It Again

Top Line: Only one direction on Tuesday and that was up. After the news from the Fed, the market decided that the world is a better place to be.

This evening's post will focus only on the Fed and its move on Tuesday. Any market direction talk needs to wait until we see at least another day of trading. We do think that the move up will be short lived but bullish optimism is difficult to predict.

We have mentioned recently that the Fed would probably Not take action between meetings to lower rates but Tuesday's action is an equivalent move. The Fed coordinated a massive central bank effort designed to "shock and awe" the markets into getting over this little credit crisis.

You have most certainly heard about it, over the roar about Spitzer, so we thought we'd give you a few highlights. This move is the most precarious the Fed has ever done, in our opinion. They decided it would be ok to accept some less than perfect assets, like non-agency mortgage backed securities, in exchange for Treasury securities which they will be able to sell in the market much easier to gain liquidity. (As someone said, the Fed has now entered the mortgage business.)

Yes, we know that is a mouthful so let's break it up and look at it again. The Fed is not the government and does not enter this financial game as the government even though the name Fed may indicate otherwise. It has assets that are used to enter the markets to protect its member banks and of course tries to make money on its ventures.

Normally, the Fed will offer to buy the safest debt securities for a short period of time to provide short term liquidity. Banks in need of reserves normally can sell Treasury securities to the Fed in exchange for Cash to cover those reserve requirements. In recent weeks and months, the banks have been offered a lot of different liquidity methods. The big one was the TAF, Term Auction Facility, which the Fed offered for a longer period of settlement than normal.

Today's announcement brought another facility, called the Term Security Lending Facility. This facility allows the banks to do some barter with the Fed in the form of trading bad debt for good. The banks offer mortgage backed securities for Treasuries. We read that the Fed may be taking a cut on these trades just because of the "risk" it is taking, so instead of giving a dollar for dollar exchange, they will be taking a dollar and maybe giving 90 cents in return.

Here is the thing: The Fed is concerned, deeply we're sure, that the banks are spinning out of control with tight credit conditions and they need to do something to preserve the banking system. The problem is that we are having a Contraction in Credit or as we like to say Debt. When debt contracts, it's a lot like Humpty Dumpty, you can't easily put it back together again.

The banks are experiencing problems due to the huge losses being taken on mortgage backed securities, subprime, yes, but Alt-A and prime, too. What the Fed is trying to do is fill the void left by billions of dollars of debt contraction. The market likes to call this De-Leveraging, meaning people and hedge funds and banks and corporations are not putting on more debt and some are actually trying to pay their debt down.

An economy like ours that seems to thrive on the expansion of credit/debt is destined to shrivel under the Contraction of debt. So, the Fed can provide liquidity to the banks or whoever needs it but what needs to happen is someone needs to actually borrow that money, create more debt, in order for the Fed's efforts to succeed.

This is deflation at its core, the destruction of money--loans that have now gone sour will never be repaid and even if the house backing that mortgage is sold there may not be enough money for the debt to be fully paid.

This part of the story is being ignored on days when the Fed opens up its doors but the facts are still out there. The Fed can not contain convince entities to borrow money.

FSI: 71.38 (a good sized jump)

Jackson was watching the ticker on Tuesday and was wondering just what the Fed was thinking:

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