The world's most influential central banks took concerted steps to improve the liquidity situation in the market, Wednesday. The unprecedented move was co-ordinated by the US Fed Reserve and included the European Central Bank as well as central banks of Great Britain, Canada and Switzerland.
It is the business of these banks to lend money to banks when there is a shortage of funds in the market and short term interest rates move up. What has surprised people is the Fed using auctions ' to inject term funds through a broader range of counter parties and against a broader range of collateral than open market operations.' The Fed says the move could ' help promote the efficient dissemination of liquidity when the unsecured interbank markets are under stress.' The Fed says, 'This is not about particular financial institutions, with particular problems. It is about market functioning.'
In practice what this means is that the Fed will lend money to banks against almost any collateral which they may offer. This would certainly include the highly illiquid CDO's and other similar instruments most of them are saddled with. The problem with these illiquid assets is that no one knows their true market value. The truth is that banks may get more by pledging such assets than by selling them in the market.
Although many banks, brokerages and investment companies have written down the value of such assets at the end of the 3rd quarter and reported large declines in profits, it is widely believed that the entire losses have not been reported and more are to follow.This is the biggest problem facing the market. No one knows exactly who stands to lose and how much. In this atmosphere of uncertainty banks and institutions are wary of lending to one another, which leads to an increase in short term interest rates.The various Central banks have sought to tackle this situation by improving liquidity. They hope that people will be reassured by their actions that everything is all right.
But everything is clearly not OK. There seems to be an air of desperation about the Fed's moves which is hard to ignore. The Fed has limited options if it wants to correct the situation merely by fiddling with interest rates. If it cuts too far it raises the risks of inflation and a decline in the value of the dollar which cannot be ignored.
The similarities between the US situation today and what happened in Japan in about 1989 are striking. In 1989 the Nikkei was at about 39,000 and real estate prices were at record highs. Share prices increased because the giant Japanese conglomerates bought shares in each other's companies, setting artificial values. Banks lent recklessly to people to buy these inflated shares and properties.Like all bubbles the Nikkei bubble also burst in 1989-1990 when the BOJ was forced to raise interest rates.The Nikkei declined to a low of about 8,000 in 2003 and even today trades at around 16-17,000. Property prices fell for 14 straight years and are showing signs of life only today.
In the US as well, loose credit has fueled the rise in real estate prices. Share buybacks by companies and a host of mergers and acquisitions has set artificial values for financial assets. The party is in danger of coming to a messy end. It is this situation that the Fed is obviously trying to avoid.It is haunted by the fear of recession and deflation if the economy cannot be turned around quickly enough.
So who foots the bill for this exercise. So far no public funds have been committed to the bail out. The Fed is hoping that it will be able to restore confidence among people and it will be back to
business as usual. If this happens there will be a gradual recovery in the housing market also, allowing banks and financial institutions to recover their money. If such a thing happens it is fine because the banks and institutions then simply redeem their CDO's which they have pledged with the Fed.But if this doesn't help and the government has to write off the debts in the end , it is the common people who will have to foot the bill. The government may have to raise taxes to make good the budget deficit. On the other hand banks,mutual funds, pension funds and other financial institutions who are managing public money may default on their obligations. This scenario is frankly quite terrifying to visualize and one sincerely hopes that Bernanke succeeds in what he is trying.