Fed Now the Middle Man in Interbank Lending Market

If this were a real war between inflation and deflation, the armies of deflation would have just cut off the head of one of inflation’s leading generals and put it on a pike as they stormed across the global marketplace, setting fire to asset values and mowing day stock markets.

So the $700 billion TARP plan, at least so far, is a total failure in reflating confidence in the stock markets. Let’s hope it fares better in repairing bank balance sheets. But if it doesn’t, what’s Plan B? More on that in moment.

Here in Australia, the local market is set to follow the global lead and head much lower. The Dow was down as much as 800 points in intraday trading. It managed to close down “just” 340 points for the day. That was good for a one-day loss of 3.3% and a close at 9,984, which is, of course, under 10,000.

You are seeing a forced, global systemic reduction in leverage. Assets bought with borrowed money are being revalued lower and sold. Against this receding tide, the Central Banks of the world are trying to decide which institutions to save and which to let go out to sea, where there will become fish food.

It’s not like the bankers aren’t trying to throw out life vests. The Fed announced yesterday an increase in its Term Auction Facility to US$900 billion. It is exploring ways to provide short-term, unsecured funding to corporations that can’t raise money in the commercial paper market-which has gone into rigor mortis.

By the way, that means the Fed won’t be collecting any collateral for prospective loans. Maybe it will accept equities as collateral. But generally, unsecured means…unsecured. That’s how bad it is in the credit markets.

The Fed is also now paying interest to banks who keep reserves with the Fed overnight. It’s a little confusing. But we reckon what’s happening is that the banks are unwilling to lend to one another, even with borrowed Fed money. So they borrow from the Fed, deposit the money back with the Fed and earn interest, and then the Fed loans the money out to other banks.

Do you see what’s happened? The banks will deposit with the Fed because it’s paying interest. But they will not loan to one another. So the Fed is becoming the middle man in the interbank lending market.

How this gets credit in to the hands of businesses and consumers is beyond our reckoning. Our guess is that it does not. That reminds us that the purpose of the Paulson plan was primarily to recapitalise the banks first and unlock the credit markets second. But it doesn’t seem to be working, mostly because asset values continue to plunge, which further dilutes bank capital.

Bridgewater Associates reckons it knows what should be done. “Ending the credit crisis will be highly unlikely without some type of accounting accommodation,” it wrote in a note to clients. “Because mark-to-market accounting on existing assets threatens bank capital today, it increases solvency concerns today, which raises funding costs and accelerates the need to sell assets today, which depresses the prices of those assets, which threatens capital and raises funding costs.”

“This cycle can be broken if banks communicated an accurate or conservative assessment of the fair value of their assets in the footnotes of their financial statements, thereby telling equity and bond investors what they need to know to value the company. But if these losses were accrued over the remaining life of the assets, thereby avoiding the immediate hit to the book value of capital, the selling pressure would be reduced, which might even allow prices to rise and reverse the cycle and improve sentiment. This seems pretty obvious without any knowledge of history, but history overwhelmingly confirms the need for such a change.”

In other words, don’t get rid of fair-value accounting. Banks would still have to keep a record of the current market value of their assets. But they wouldn’t have to revalue the assets based on that market value. That change might break the relentless cycle of asset selling, higher credit spreads, and more selling.

Then again, maybe it won’t. Who knows? Maybe the Feds should bust Andrew Fastow out of Federal prison and set him loose on Wall Street’s books. Remember Fastow? He was the lead account for Enron.

Along with Ken Lay and Jeffrey Skilling, Fastow set up a bunch of off-balance sheet partnerships-which he called Special Purpose Entities and named after Star Wars characters…i.e. “Chewco” and “JEDI”-to park Enron’s debts and assets as far off the balance sheet as possible.

Enron went from being America’s seventh-largest publicly listed company to a $31 billion bankruptcy story, which looks like small potatoes these days. But for awhile, Fastow was able to juggle the assets and debts and make it look like Enron was actually a going concern.

Here’s an idea: Free Andrew Fastow! Put him in charge at the Treasury Department! You have to wonder if the Paulson Plan is any different in kind than the Enron Plan-an attempt to keep assets in escrow until they increase in value…or are simply forgotten about.

Dan Denning
Markets and Money

Dan Denning
Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.

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I have an idea to fix the financial crises and its so easy I cant believe the US has not thought of it yet. I’ve done some research and found out that the board game Monopoly is one of the most popular games ever. Its been selling since 1935. I would make a guess and say there are hundreds of millions of board games out there around the world meaning probably a trillion or so Monopoly dollars out there in peoples homes. We should use this money to bail out the financial system, Yes everyone should go running out of… Read more »
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