The Fed Fights On
Posted by Index Protrader Services at 3/13/2008 5:38 AM and is filed under Current Events and Timely news 
Two money market interventions by the US Federal Reserve in three working days are confirmation, if any
were needed, that the credit markets remain sickly. Though the Fed is right to try, its latest action is
unlikely to have much effect.
In addition to rate cuts, Fed intervention has escalated since it cut its discount rate last August. Last
December it began offering $20bn of 28-day loans twice a month, it increased that to $30bn in January,
and has now upped it to $50bn. Last Friday it announced another $100bn of term liquidity, so there will
soon be a total of $200bn in longer-term Fed finance that was not on offer three months ago. It has not
prevented another spike in the rate at which banks will lend to each other.
Yesterday's move was different. The Fed is not offering to lend cash in exchange for bonds, it is offering to
lend up to $200bn of Treasury bonds in exchange for triple-A mortgage-backed bonds. Unlike mortgage
bonds, Treasuries are still easy to borrow against in the private markets, so making it possible to
exchange one for the other is a sensible attempt to ease the short-term pressure on leveraged investors.
Whether it has any effect depends, as it has with every central bank intervention since last July, on
whether this is a crisis of liquidity or solvency. If it is simply the case that banks do not have the cash to
lend against mortgage bonds then this will have an effect. If, on the other hand, banks are worried that the
mortgage bonds or their owners will default, then they will be unlikely to lend even if they can refinance at
the Fed.
Banks' need for liquidity is hard to observe directly, but the evidence implies that the greater problem is
solvency, and that the latest intervention will therefore have little effect. First, the price of insuring the
credit risk of banks' own debt has soared, suggesting worries about their solvency. Second, even triple-A
mortgage bonds have fallen in price, and a number of leveraged investors, such as Peloton Capital, have
failed. That suggests ample reason to worry about repayment. Third, Wall Street banks insist that they
have plenty of cash.
There is something the Fed can do about solvency - take all of the credit risk on to its own books. It has
already taken the first steps in that direction: if any of its primary dealers default, the Fed will be fully
exposed to the risk of the mortgage bonds that are deposited with it. But the Fed should not bail out the
banks unless there is a systemic crisis. We are not there yet. Whether we get there depends on how far
house prices fall and how bad the real economy becomes.
Originally published at Financial Times on 3/12/2008
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