Wednesday, March 12, 2008

TSLF: market is not impressed.

Stock markets have rallied yesterday on the news of TSLF but the real measure of stress in the financial system is TED spread (graph), which indicates how much risk investors see in lending to banks. The higher this spread, the more risks lenders perceive. And in response to an unprecedented and extreme move by the Fed, the TED spread... barely budged.

Maybe because of this stock market traded down today and dollar tanked over 1% (USD to EUR is down 6% this month alone). Treasuries gained back everything they lost yesterday, suggesting that flight to safety has not abated.

If market does not believe that this action by Fed will restore trust in the system, what else can Fed do? It can slash rates further, from 3% to 0%, but considering that they are already in the uncharted territory of experimental monetary tools, they do not believe this would help much. They will cut, sure, but it does not address solvency problem. Another thing they could do is just buy the tainted assets like ABS outright, taking on risk. But this step would be so far outside the Fed mandate, it would probably require Congress approval first. Even if they do that, it would most likely amount to money injection and trigger a surge of inflation, so it's a no-win move.

I think deep down inside Fed officials know that they deal with solvency crisis, not just a liquidity one. And monetary tools cannot cure insolvent institutions. The reason Fed was implementing all these extraordinary measures is that they are trying to at least alleviate liquidity problems for those businesses which are sound and solvent. But the snag is, the only way Fed can lend money to ordinary companies is through primary dealers - big banks. However, what market is telling the Fed right now, is that it is the primary dealers who are insolvent. Confirming the suspicion, the primary dealers do not have the capital to take on more risk and are not lending out money.

With insolvent middle man stuck between the source of money and the solvent but illiquid companies, the situation resembles a stalemate. Or maybe a checkmate.

The last and ultimate thing Fed could do is to invoke the right it has to lend freely to any individual or company in the emergency situation. This has never been done before, not even in the worst crises. Fed does not have either the manpower nor the expertise to make loans to arbitrary companies. Will they try it? I doubt it, but who knows.

One thing for sure, if you hear the news that Fed is now lending money directly to companies like General Motors, then you know it has given up on saving the banking industry.

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