The Fed is Playing With Fire

The market roared today as the cheered the Fed's moves this week of cutting rates, bailing out Bear Stearns, and allowing investment banks to borrow from the discount window. The road the Fed has decided to take is full of danger according to many expert. It also in my opinion sends the wrong message to the banks.

CNBC reported the data showing how much borrowing was done at the Fed discount window by the investment banks. The data was disturbing:



"Those large firms averaged $13.4 billion in daily borrowing over the past week from the new lending facility. The report does not identify the borrowers.
The Fed, in a bold move Sunday, agreed for the first time to let big investment houses get emergency loans directly from the central bank. This mechanism, similar to one available for commercial banks for years, got under way Monday and will continue for at least six months. It was the broadest use of the Fed's lending authority since the 1930s.



On Wednesday alone, lending reached $28.8 billion, according to the Fed report."



I almost fell out of my chair when I read how much was borrowed. These are HUGE amounts of money!!! This told me all I needed to know about how bad things really are with the banks and their balance sheets. In the past the banks would never borrow from discount window because they were worried it would look like a sign of weakness. I guess when you are bordering on insolvency things change and that discount window doesn't look so bad anymore!!

All the big names including Goldman, Lehman, JP Morgan and Merrill Lynch were all shown to have used the window. Based on the amount borrowed, my guess is at least one of these banks would have gone down with Bear this week if the Fed hadn't changed the rules and done something for the first time ever and lend to the slime that got us into this mess to begin with.



Think about the message you are sending to these investment banks if you are the Fed. You are basically telling the banks "Its ok that you committed fraud and put millions in homes they cannot afford. We will have your back when they cannot afford to pay." When will the Fed realize that they may have crossed the line of moral hazard? How can you reinforce such horrible behaviour? It really boggles my mind.



What the Fed is allowing the banks to do is take bad debt to the discount window and turn it into cash. This is flat out WRONG and who do you think pays for this? That's right the taxpayers. This is going to turn into a nightmare if the Fed continues this bailout behaviour. No one can afford houses right now! No one wants to lend money to buy at these prices! By feeding the banks money and allowing them stay afloat the Fed is doing nothing but freezing up the system which will make things MUCH WORSE down the road.



Economics professor Noriel Roubini who has been dead right on this crisis from the beginning explains it best here:

"The Fed response to this run has been to provide the Bear Stearns bailout and provide both liquidity and swap of illiquid and toxic assets for safe Treasuries to the non-bank primary dealers. But these radical and risky actions of the Fed - as the collateral for this lending is now toxic – are not achieving their goals: in the short run the risk of a run on a Lehman may have been reduced; but what is happening in the money markets and in the agency markets shows that the Fed can only affect partially liquidity premia, not credit premia; and spreads are widening for a wide range of money markets and credit markets because of widening credit spreads driven by sharply rising counterparty risk.

The lack of trust of financial institutions in their counterparties is surging in spite of all the Fed actions as panic is setting in money markets and credit markets. Thus, providing access to a dozen broker dealers who are primary dealers does nothing to ease the credit risk and liquidity/rollover risk of thousands of US and global institutions that are part of the shadow financial system. In a mark to market world many of these highly leveraged institutions – including large broker dealers other than Bear Stearns – are effectively bankrupt and no Fed action can rescue them. And the run on the shadow financial system has barely started.

Thus the piecemeal approach to crisis management taken by the Fed, the Treasury and other financial authorities is going to fail miserably. A severe recession and a severe financial crisis cannot be avoided at this point. Only much more radical government action will limit the financial meltdown and start to put a floor on the financial markets collapse. This government intervention would not be aimed to prevent the necessary adjustment of asset prices; it would be aimed at ensuring that the necessary adjustment is not disorderly."

Bottom line from Dr. Roubini: You can bring a potential lender to water but you can't make him drink. The Fed and banks can only provide the liquidity. The problem and ultimate failure of this charade is the demand to lend simply isn't there because people are tapped out and done lending. The Fed cannot create DEMAND no matter how hard it tries.

If the Fed continues on this path then we are in deep trouble. They cannot continue to bailout the banks forever because they will go bankrupt themselves. As I have said before the FED does not have enough money to cover the bank losses. They cannot continue to lend at $30 BILLION per day. The fact that the Fed is lending to the thieves that put us into this disaster should anger every American.