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Wednesday, March 12, 2008

The Big Test: Saved by the Fed

The big news yesterday was of course the new $200 billion lending facility announced by the Fed at 8:30.

Fed to Lend $200 Billion, Accept Mortgage Securities (Update10): “The Federal Reserve, struggling to contain a crisis of confidence in credit markets, will for the first time lend Treasuries in exchange for debt that includes mortgage-backed securities.

The Fed said in a statement in Washington it plans to make up to $200 billion available through weekly auctions. Officials told reporters on condition of anonymity that the program may be increased as needed. The Fed coordinated the effort with central banks in Europe and Canada, which plan to inject up to $45 billion into their banking systems.

U.S. stocks rallied the most in five years on optimism the initiative will help avert a wider credit crunch. Treasuries fell and the premiums investors demand for debt backed by home loans guaranteed by Fannie Mae retreated from close to a 22-year high. Fannie Mae and Freddie Mac, chartered by the government, are the largest sources of money for U.S. home loans.”

So let me get this straight. I could now walk up to the Fed with my crappy mortgage backed securities and trade them in for rock solid Treasuries? Sure, I’d have to take some kind of haricut, but I can turn something nobody else wants at any price and is therefore effectively worthless, into something liquid and valuable? I take something that is difficult, if not impossible to value and trade it in at what price? I take something with real credit risk and trade it in for something with no credit risk. Junk for gold. Awesome. Just awesome.

While this does add liquidity to the system, it doesn’t do much beyond that. The insolvency issue still remains unaddressed. If you couldn’t pay your mortgage before, you still can’t. Home prices will still continue to correct. The banks still won’t expand their lending and stimulate the economy. They know these measures are temporary and they know their collateral will continue to deteriorate. Every 28 days, they will have less collateral value to swap for Treasuries as their mortgage backed securities continue to shrivel up in value.

In the meantime, lets squeeze the shorts.

On March 5th, in my post The Big Test is Pending I argued that equity indices the world over will test their January lows and that failure there would be catastrophic. Yesterday would have been the day of reckoning. Without the Fed announcement, the markets would have slid into the abyss.

Since they all look the same, from the S&P 500 to the Shanghai Composite, I’ve only put up some of the indices in today’s post.

Money-Market Rate for Euros Rises After Fed's Action (Update1): “The cost of borrowing euros for three months rose for a seventh day, signaling central bank measures to combat the credit squeeze are having limited success.

The difference between the rate banks charge for three- month euro loans relative to the overnight indexed swap rate, the so-called Libor-OIS spread, showed a decrease in the availability of cash for borrowing, rising 2 basis points to 61 basis points. The spread was 42 basis points a week ago. It averaged 6 basis points in the first half of 2007.”

I’ve been mentioning LIBOR and EURIBOR for the last two weeks. These very sensitive measures of financial system stress have been quietly creeping higher. That they remain elevated after yesterday’s Fed announcement does not bode well for risky assets.

Stock Investors Grow More Pessimistic on U.S. Recession Concern: “Stock investors in the world's biggest markets are growing more convinced equities will fall in the next six months, a survey of Bloomberg users showed.”

How about equity investors are becoming more and more REALISTIC.

Related Headlines:
Fed Seeks to Limit Slump by Taking Mortgage Debt (Update1)
House's Frank Says Municipal-Bond Rating Scale `Ridiculous'
[EDIT: 03/11/08 - 9:20 AM]
Related Posts:


Anonymous said...

Not so fast...
Looks like the markets smell the scent of death in the air..

Ben Bittrolff said...

That scent of death is the stink of Caryle Capital defaulting on $16billion... blowing a giant hole into several banks in the process... (Caryle Capital is long illiquid mortgage backed securities on 32:1 leverage.)

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