Another day, another massive liquidity injection into financial markets orchestrated by the Federal Reserve. This time around, the Fed is making $200 billion worth of U.S. Treasuries available to a group of elite Wall Street bond dealers and banks.
Technically, the Fed's move is not a bailout. To gain access to the Treasuries, the borrowers must give the Fed collateral, and then pay back the loans in 28 days. The Fed announced it will accept mortgage-backed securities as collateral, provided they are government-backed or enjoy gold-plated Triple A ratings.
At the moment banks are finding it extraordinarily difficult to unload their holdings of mortgage-backed securities, no matter what kind of rating they enjoy. The result: an-artery clogging credit crunch. Nobody is willing to lend -- in fact, the opposite is true, everyone wants to call in their chits. The hope is that by making highly liquid Treasuries available in exchange for unpopular mortgage bonds, the banks will feel more confident about their balance sheets and be more willing to lend cash to other institutions. This could offer a lifeline to Wall Street's walking wounded, such as the distressed hedge funds currently forced to sell off their assets in order to meet margin calls.
Will it work? The new Treasury loans won't even be available for another two weeks, but financial markets in the United States were immediately ecstatic -- the Dow Jones industrial average rocketed up 260 points in early trading, and closed up 416. But that's just a short-term Rorschach ink blot reaction. We can ignore it. What we can't ignore is that market indexes were at 18-month lows on Monday, and a host of economic indicators measuring real economic activity have been resolutely negative.
The financial press is replete with praise for the Fed's innovative maneuvering. We are being told that Bernanke has figured out a way to goose the financial markets back into life without employing the heavy artillery of potentially inflationary rate cuts. And I suppose on one level one can applaud simply the act of trying to make a difference. The Fed is doing what it can to address serious economic problems.
But there are some important caveats. As Barry Ritholtz of the Big Picture told the Wall Street Journal, the move "will do nothing to help the housing market, or stop the decline in house prices. Nor will it help resolve the inverted pyramid of derivatives that sits atop housing." Which means that the fundamental economic force that has been propelling the overall economy downward remains unabated.
And what happens when the banks pay back their loans? Will they then find it any easier to trade their holdings of mortgage-backed securities? And just how solid are those supposed Triple A ratings? A report published by Bloomberg News on Tuesday gives the strong impression that more bad news is on the way.
Even after downgrading almost 10,000 subprime-mortgage bonds, Standard & Poor's and Moody's Investors Service haven't cut the ones that matter most: AAA securities that are the mainstays of bank and insurance company investments ... A bond sold by Deutsche Bank AG in May 2006 is AAA at both companies even though 43 percent of the underlying mortgages are delinquent.
Sticking to the rules would strip at least $120 billion in bonds of their AAA status, extending the pain of a mortgage crisis that's triggered $188 billion in writedowns for the world's largest financial firms...
"The fact that they've kept those ratings where they are is laughable," said Kyle Bass, chief executive officer of Hayman Capital Partners, a Dallas-based hedge fund that made $500 million last year betting lower-rated subprime-mortgage bonds would decline in value. "Downgrades of AAA and AA bonds are imminent, and they're going to be significant."