The Fed today announced to inject another thick pile of billions into the credit markets:
The Fed, the U.S. central bank, said it would launch a "temporary term auction facility" that banks can use to secure loans at its discount window.
"This facility could help promote the efficient dissemination of liquidity when the unsecured interbank markets are under stress," the Fed said in a statement.
The banks do not trust each other anymore. They refrain from lending one another on normal terms. This because no one knows how much bad debt any bank is holding. There are just too many off-balance-sheet vehicles out there holding bad debt: mortgages, car loans, credit card loans. Who owns these vehicles? What is the real value of their holdings? What happens if they have to liquify their holdings? Will their sponsor bank have to take the loss? Does it have enough capital to take the loss?
All these questions are open. Now the Fed steps in and takes on the risk other banks do not want to take. The NYT’s Floyd Norris sees Fear at the Fed:
The combined actions of the world’s central banks on Wednesday smacks of a real fear that the world’s financial system is in trouble.
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The Fed will lend money to banks based on almost any asset they own, even ones that are not liquid at all. That will include some of the more exotic loans and securities out there.
The Fed will ‘create’ and dispense fresh money and accept junk as collateral. It hopes that the lenders will be able to pay back. What happens if they can’t?
Numerian thinks:
This is the very type of “slippery slope” that the Fed warns its banks about. A little risk here, and another little risk there, leads to increasingly inability to refuse taking on ever-greater risks.
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Somehow, for nearly a century of operation, the Federal Reserve functioned well by accepting only a limited type of very high quality collateral for very short term periods from its member banks. Now it is on its own slippery slope. Its only real asset is its credibility, which in the markets is currently very high. But central bank credibility can be lost as quickly as liquidity can one day exist in abundance and the next day disappear.
It would be fine for the Fed to pursue such actions and take the risk, if it would have a chance to solve the problems. It does not. Roubini:
[T]his is the first real crisis of financial globalization and securitization; it will take years of major policy, regulatory and supervisors reform to clean up this disaster and create a sounder global financial system; monetary policy cannot resolve years of reckless behavior by regulators and supervisors that were asleep at the wheel while the credit excesses of the last few years were taking place. Now the US hard landing and global sharp slowdown is unavoidable and monetary policy – if aggressive enough with much greater and rapid reduction in policy rates – may only be able to affect how long and protracted this hard landing will be.
Today the Fed can still influence the markets and the general economy by talking tough and taking small steps in its monetary policy. But what it announced today indeed smells of panic and loss of self confidence.
There will come market situations where the Fed is needed and could really matter, like a general run on consumer banks or a Dollar crash. When the Fed takes on too much risk and starts to lacks credibility, its effect in times of real crisis will be less than is to desire.