The Fed’s Mistakes – How Deep In It Now?

| March 18, 2008

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In a recent private discussion thread, one of the participants cited our current problems as a shortage of liquidity (available cash) brought on by failed sub-prime mortgage lending.

We are not a liquidity crisis, but a debt crisis. The banks have some idea of how bad the problem really is, but most people don’t know or would choose not to believe anyhow. As a result the banks worry about lending to each other for 2 reasons: 1) They need all available capital on hand to cover their growing losses 2) They worry that whomever they lend to is actually insolvent and will never repay. #2 is what just happened to Bear-Sterns.

The banks still have plenty of money, but they are now allocating it to defensive posture because they are holding a lot of bad debt, and amount that is growing every day. This is not so much sub-prime mortgages as it is the derivatives on mortgage backed securities. These are starting to blow up now, and firms that used massive 30:1 or higher leverage are finding out they cannot cover the margin calls they are getting.

So they get afraid about how screwed they are and stop lending. They don’t really take the time to find out how screwed they are, because if they did Sarbanes-Oxley would force them to report it, which would cause a panic / drive their share prices down. So they motor along blind to their actual state of affairs because it is advantageous to do so. As a result they are hoarding money.

The Fed steps in and tries to help. They make it easier for banks, and now big investment firms, to borrow money directly from the Federal Reserve. Many financial institutions are all too happy to do that. But instead of using the loaned money to move the economy forward, they are hoarding the cash because of items #1 and #2 above.

As a result the debt system, which is what has been driving our economy for the last 20 years, freezes up solid. The money (liquidity) is around, but the firms that control it are keeping it for themselves. Everyone else gets to use debt, and the debt situation is bad and trending worse recently.

Right now the biggest banks and the biggest investment houses are in survival mode. They are looking for any legal way they can to survive the current and coming events. They don’t care if the other company makes it or not. In fact, as we say with Bear, they are going to try and eat the weaker ones in order to survive as bigger entities on the other side. What is amazing is the action in Bear-Sterns was assisted and funded by the Federal Reserve itself.

The US Federal Reserve continues to try every manner of action to hold back what is likely inevitable: a partial collapse of the US and possibly world financial system. Such a collapse is probably needed to clear out the excesses and mis-allocations of the past 10 years. The party lasted a good long time, but it’s time to sober up.

Anyone who tells you they know what happens next is most likely wrong. We are in uncharted waters right now.

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Category: Commentary, Credit Backlash, Economics

About the Author ()

Bruce Henderson is a former Marine who focuses custom data mining and visualization technologies on the economy and other disasters.

Comments (1)

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  1. Jeffrey Carr says:

    Thanks for putting up this post, Bruce. I’m wondering how far the Fed is willing to go to keep putting off the eventual burn-down of financial institutions that gambled and lost.