Tuesday, March 11, 2008

Explicit FED Backing for Off Balance Sheet Tomfoolery

The sun was very bright and strong today, and it seemed the solar power transferred to the markets as well! Daylight savings time was this past Sunday, and the Bernanke "Light of Day" savings time for the banks came today.

Explicit FED Backing for Off Balance Sheet Tomfoolery
You may have noticed the ripper to the upside day that occurred. It was quite the fireworks show indeed. The latest and greatest move by the FED is both disgusting and perfectly fitting for the situation.

From Yahoo Finance:
Stocks Shoot Higher on Fed Credit Plan
Tuesday March 11, 4:59 pm ET By Joe Bel Bruno, AP Business Writer
Dow Jumps More Than 400 Points After Fed, Other Central Banks Move to Ease Credit Crisis
NEW YORK (AP) -- Wall Street finally found a reason for a huge rally Tuesday after the Federal Reserve said it plans to pump $200 billion into the financial markets to help ease the strain from the credit crisis. The Dow Jones industrial average shot up more than 416 points, its biggest one-day point gain since July 2002.
The Fed's program is part of a worldwide effort to help struggling banks and mortgage providers. The Fed -- acting in concert with the European Central Bank, the Bank of Canada and the Swiss National Bank -- agreed to loan investment banks money in exchange for debt, including slumping mortgage-backed securities.
The move is meant to essentially create a market for assets that investors have been too scared to buy. That freeze-up in demand had sent asset values plunging and caused huge losses for some of the world's biggest banks.

It's not just a rate cut. I think it's a very creative way to do financing," Conroy said. "It shows the Fed is willing to do things that are a little out-of-the-box to shore up credit issues. I really think they went to the heart of the issue."
The latest step was seen as a direct lifeline to investment banks, which previously couldn't borrow in past Fed liquidity plans.
"The big problem has been the financials, and this helps supply money directly to the banks and may take some of the need for aggressive rate cutting off the table," said Peter Dunay, chief investment strategist at Meridian Equity Partners. "The Fed is basically going to take the bad loans off the banks' books, and the market seems to be loving that idea."
The central bank may have avoided dramatically slashing interest rates again when it meets next week. Economists remain concerned about the unrelenting rise in oil prices and the dollar's weakness, which contribute to inflation -- and cutting rates only add to these pressures.

So there is your headline and mainstream news wrap. There is so much to cover in just this short piece!

Let's start with the FED's plan. The FED will take as collateral the same toxic mortgage paper that the banks are unable to sell. The paper is so bad, there is no market for them. But the paper is rated "AAA" the bulls say, but we need not go into the details of the ratings game do we? You know this plan is not targeting good paper, but the massive capital losing crud the banks are swimming in.

So short term, a bank can give the FED the bad stuff, and get treasuries in return. The treasuries are super liquid and the thought is that this new source of capital will push the banks to open the loan flood gates again. Maybe I am just stupid (it is highly possible) but there seems to be a few problems with this line of thought:
  • The loan is for 28 days (for now at least!). Does anyone think that by the end of April the poor mortgage paper will suddenly become good? What happens on May 1st when the swap back occurs?
  • With the ongoing fall in home prices and the still accelerating foreclosure numbers, what bank is going to want to start generating MORE loans for residential or commercial real estate? How indeed is this going to improve lending?

Those are my two major questions. I have not seen them brought up as yet anywhere else mainstream.

Off balance Sheet Tomfoolery

With this move by the FED, Bernanke and company basically embrace the "Funny Numbers" game played by Wall Street for the last decade. The issue right now is that most banks are stuffed to the gills with rapidly deteriorating assets related to mortgages. The banks are so leveraged and under capitalized that they are in fact insolvent. Any real world application of value to these assets will result in real problems. The solution proposed by the FED? Just hide the losses in an off balance sheet account! What better, more legitimate way to hide and delay losses than to stash it at the FED at the FED's request! This is too rich! I mean just when you think things cannot get anymore messed up, in comes the FED to make sure it does!

Think that is just my uninformed opinion? I suggest you reread the quote from the insightful Peter Dunay from Meridian again very slowly:

"The Fed is basically going to take the bad loans off the banks' books, and the market seems to be loving that idea"

There it is. We see again the ability for the markets and it's participants to ignore reality and instead occupy the mythical fantasy land where Bernanke rides in on his white UNICORN and waves his magical wand and presto! Disaster fixed! The market indeed does love the idea of banks being able to ignore their losses and carry on as if nothing ever happened. Who wouldn't love that deal? The suspension of disbelief is astounding. The banks are insolvent and capital impaired, so the solution is to ignore all that and pretend otherwise. I gotta admit, it is becoming more attractive a possibility for me every day! I think the quote above tells you all you need to know about the current state of the financial world we are in. The FED has given explicit backing to the off sheet hiding of losses that was made so popular by the likes of Enron and other pillars of US financial history. Wonderful.

Market May Have Screwed Itself

Until proven otherwise, the saying that nothing in this world is free will always be true over time. I believe the market may be setting itself up for a problem after the silly mega rally that happened today. What am I talking about? Reread some of the articles that pertain to this action by the FED and they are all setting up the possibility for a small rate cut next week. The chances for the desired 75bps cut plummeted today. What happens if the FED cuts by 25bps? What if they do not cut at all? I think the markets will go wildly to the downside. The rally today may make Bernanke think he is ahead here, and with constant reminders of commodity prices skyrocketing, the FED may want to slow down the destruction of the dollar.

Do not get me wrong, rates are going down significantly from here. How we get there will be the issue. The market wants the following from the FED:

  • The 200 Billion on the table for bad mortgage paper
  • Another say 500-900 BILLION for the same purpose
  • The ability to park bad debt at the FED for practically forever (no swap back!)
  • Interest rates in the 0%-1% range by August

Any deviation from this list will kill the markets. Of course they will get all this and more, but I think there will be some speed bumps along the way. The first is scheduled for next week!

In summary, we had a glimpse of the rot and sickness of the system today. The FED enabled banks to play "hide the salami" as it pertains to losses, and instead of laughing at the idea of pretending everything is all better the markets embraced the illusion fully. It is unsettling the degree at which things have become disconnected from any reality. It is becoming harder and harder every day to keep from wanting to join in.

Have a good night.


Anonymous said...

Let's see we have had:
"It's contained"
"Were not going to bail out speculators'
"The economy is strong"
"We have a strong dollar policy"

And here we are with the FED basically monetizing toilet paper.

I don't know what the FED will do but I think the market will get the 75bps even though they would be better off going with 25 which would probably knock the commodity markets at least short term the FED follows the market it does not lead it. I dumped some more silver today as a precaution of less then 75 happening. I think in a week or so I'll add to the bear funds depending on what transpires over the next week or so S&P 1360 looks pretty likely to me. I took a good hit today on the bear funds but over the next year or so the equity market is headed a lot lower IMOP.


Anonymous said...

The risk of losses on U.S. Treasury notes exceeded German bunds for the first time ever amid investor concern the subprime mortgage crisis is sapping government reserves, credit-default swaps prices show.

``The U.S. government is not immune from the consequences of the credit crisis,'' said Fabrizio Capanna, BNP's head of high-grade corporate trading in London. ``Support for troubled financial institutions in the U.S. will be perceived as a weakening of U.S. sovereign credit.''


Uh Oh!


Anonymous said...

Is there a likelihood of no cut? It hasn't helped with interbank lending; the FED may wait to see what the 200B does. I vote for a pause via a cross Atlantic plea.

watchtower said...

Unbelievable. Jim Puplava is right, the government will make this worse.

Prepare accordingly.