For the third time today, the Federal Reserve has intervened to provide liquidity to banks at its discount window. After the second intervention, CNBC reported that the size of the Fed’s two interventions was larger than in any day since September 2001. The third intervention was a very small addition ($3 billion) to the other two ($35 billion).
What the Fed bought was mortgage-backed securities, the market for which has dried up. According to CNBC news reports, the Federal Reserve was forced to act because US banks have been reluctant to lend short-term money to each other. As banks refuse to cooperate in the usual way because of the spreading credit crunch, the possibility of major problems over the next few months accelerates.
UPDATE: On further investigation, it is unclear whether news reports of the Federal Reserve buying mortgage-backed securities are in error.
From reading the Fed's website, I think that the Fed may have merely accepted such securities as collateral for three-day loans.
2D UPDATE: Two of the expert talking heads on CNBC are now saying that the Fed did not buy mortgage-backed securities today. Rather, according to them, the Fed accepted the CDOs as collateral. The two experts then disputed whether the Fed had effectively provided a price for these securities that are not being publicly traded. It would appear from the Fed's margin requirements for collateral that an implicit minimum price would have been set by the Fed's acceptance of them.
If so, I would hope that banks, hedge funds, and public corporations would mark their investments to market as quickly as possible so that the capital markets can adjust to this latest estimate of value, even if it is flawed. As this credit crunch is playing out, almost every day for nearly a month, we hear of new problems surfacing in new places. As some VC commenters have noted, we don't want a long-term refusal to mark assets to market, as occurred when the Japanese real estate market collapsed in 1990.
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Don't forget that the fed "pays" for the securities by creating money out of thin air. Say hello to inflationary doom.
I would rather that the Fed lowered interest rates than bought bad paper (if that is what happened).
The current market for CDOs is so illiquid that it would be hard for an outsider to judge whether the Fed overpaid for the CDOs.
If the Fed did overpay, and if the banks don't have to take back their CDOs when the 3-days repos expire (sorry, I don't know enough about 3-day repos to know what happens in 3 days), then the Fed's action today would indeed amount to a very limited, partial bailout of some banks.
Paging Mr. Bernake... please inject some liquidity into the used Mazda market.
It's worse than I thought.
Here is a quote from Forbes describing a 3-day repo:
So the dealer selling a CDO could be a bank or a hedge fund or a mortgage broker or just about anybody.
In relative terms, the big losers this week were hedge fund investors and not Main Street retail investors. However, the hedge fund investors are more capable of bearing the investment risks because they are more sophisticated than Main Street retail investors (like yours truly). Therefore, Bernanke should just let the market correction run its course and let the hedge fund managers collectively cry over their martinis tonight about how they are only going to be paid $1 Million this year instead of $1 Billion.
Personally I am not convinced yet the party can't go on for a while longer but avoiding hyper-inflation would be a problem. The deflationist case is not bad though and certainly the upside down derivative pyramid of doom appears to be rupturing in a black swan event right now. We live in interesting times!
I leave with a quote :
"The issue which has swept down the centuries and which will have to be fought sooner or later is the people versus the banks." Lord Acton
When the banks back our money with gold, there is no central bank (let the market set the rates), and fractional lending is abolished then I will be fond of banks again.