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Friday, August 17, 2007

The Fed's Psychological Move

After attempting to prop up the US markets on August 9 and 10 of 2007 with an unprecedented $62 billion dollar injection and watching the markets slide for another week, the Fed called another surprise audible at the line of scrimmage on August 17.

Last week, it agreed to materially lower its quality threshold for collateral used to secure overnight borrowing for cash while initiating an unprecedented injection of funds on those looser terms. The move was prompted by major banks all reaching the same conclusion at the same time -- customer demand for cash outstripped their willingness to trust mortgage backed securities as collateral for loans among themselves. In essence, they all simultaneously realized they were holding the same empty bag -- or at least a bag filled with question marks.

Despite the $62 billion dollars injected August 9 and 10, banks and investors gained little confidence and stocks declined for four straight days despite additional injections from the Fed. On August 17, the Fed intervened again by lowering the rate it charges for "discount window" loans AND extending terms from overnight to thirty days. Manipulation of the discount rate is nothing new. Converting discount window terms from overnight to thirty days is another matter entirely. The extension of terms for discount window borrowing in the current climate is the financial equivalent of sending a teenager cross-country in a Camaro with a case of beer and a cell phone after they already crashed the family sedan pulling out of the driveway. The financial markets have already demonstrated

1) they cannot be trusted to enforce adequate credit standards at the retail level
2) they cannot be trusted to properly evaluate the risks of securities sold to one another
3) they cannot be trusted to cut their losses early instead of doubling down in search of a greater fool

With these facts already in evidence, the Fed's move reinvented fundamental mechanics of its "lender of last resort" function by creating MORE of the arbitrage opportunities that have already destabilized the entire banking system.

The only FOR argument for the Fed's action is that extending the terms gives the market additional time to reach some conclusions about the true value of the bundles of mortgage backed securities and let those adjustments trickle through the system in an orderly frenzy rather than an outright panic. The arguments AGAINST this move have already been itemized above. Banks have already demonstrated they cannot properly judge the risks associated with complex bundles of loan securities of unknown, mysterious provenance. Banks have already lost tens of billions of dollars attempting to operate hedge funds specializing in these high-risk segments of the market.

The players are all the same. The incentives are all the same. The stakes are getting bigger. The Fed continues to instill false confidence in a financial safety net big enough to catch every bank falling off the high wire at the same time. Are we really expecting a better result this time?

Virtually all of the talking head market watchers asked to comment on the August 17 intervention described it as a "mostly psychological" move by the Fed. For once, they're right. This is absolute INSANITY.