'Intelligent discontent is the mainspring of civilization.' -- Eugene V. Debs

Monday, March 17, 2008

UPDATE: Keep Score While Rome Burns 

UPDATE to the UPDATE: Half the world will be slashing rates this year to stave off credit contraction.

Even the weekends, when markets are closed, require urgent action by the Federal Reserve:

In a potentially even bigger move, the Federal Reserve also announced its biggest commitment yet to lend money to struggling investment banks. The central bank said its new lending program would make money available to the 20 large investment banks that serve as “primary dealers” and trade Treasury securities directly with the Fed.

Much like a $200 billion loan program the Fed announced last Tuesday, this program will essentially allow the government to hold as collateral a wide variety of investments that include hard-to-sell securities backed by mortgages. But Fed officials told reporters on Sunday night that the new program would have no limit on the amount of money that can be borrowed.

In a conference call with reporters, the Federal Reserve chairman, Ben S. Bernanke, said the central bank was moving to provide money to financial institutions that need it.

“The Federal Reserve, in close consultation with the Treasury, is working to promote liquid, well-functioning financial markets, which are essential for economic growth,” he said. “These steps will provide financial institutions with greater assurance of access to funds.”

While the purchase of Bear Stearns by J.P. Morgan, assisted by financing from the Federal Reserve, will get most of the media coverage, as it did in the New York Times article linked at the beginning of this post, it may well be this program, a program that enables primary dealers to exchange their toxic financial instruments, like mortgage backed securities, in unlimited amounts for US treasuries, that will be remembered as the most significant.

Of course, the policy is based upon the notion that the instruments provided as security for the loans will retain, and perhaps even enhance, their value through more orderly selling in the market over time. But there is good reason to be suspicious. Vulture funds, which have already visited and walked away from the scene of the accident, have declined to buy them, even at heavily discounted rates, because they could find no way to confidently ascertain their value.

Why should the Federal Reserve assume that the passage of time is necessarily going to improve the situation? In the 1990s, Japan was known for its zombie companies, companies keep alive by the lenders and shareholders, even though, as the term implies, they were moribund. Now, the US may be known for the Federal Reserve taking zombie notes off the hands of zombie banks and zombie brokerage houses. Guess who going to end up paying the bill?

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