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Wednesday, December 12, 2007 12:45 PM

Fed's Auction Scam

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Typing from Ohare Airport where my flight is delayed I see the Fed Futures soaring on a new wrinkle in the the Fed's willingness to do anything to keep the bubble alive. The report from Bloomberg is Treasuries Fall as Central Banks Seek to Ease Credit Concerns

Treasuries tumbled after the Federal Reserve said it will stem a surge in borrowing costs by adding cash to banks through auctions and providing $24 billion in currency swap lines to European central banks.

The Fed is coordinating the measures with the European Central Bank, Bank of England, Bank of Canada and Swiss National Bank, the Fed said in a statement in Washington. The Fed will auction term funds to banks against a "wide variety of collateral." All "generally sound" institutions can participate, the Fed said in a statement.

The central banks are taking the steps after demand for cash sent borrowing costs climbing. The Fed's previous attempts to ease the credit squeeze that began in August have failed to have lasting effects. One gauge watched by central bankers, the three-month dollar London Interbank Offered Rate, rose to 5.15 percent a week ago, the highest in almost two months.
Yesterday in Fed Tiptoes Thru The Tulips in regards to the quarter point disappointment I stated:
"I am unwilling to give Bernanke any credit here because I suspect the only reason he is not cutting more aggressively here is to save his surprises for later and/or he simply does not understand the situation at hand.

He has already shown a propensity to surprise, with a discount rate cut during options expiry week.If credit markets continue to act poorly, there will be more surprise discount rate cuts and surprise rate cuts as well. Bernanke does not have "kind of stones" it will take to let the market play out by itself."
Well here we are one day later in yet another Bernanke surprise party.

Minyanville's Mr. Practical had this to say about The Fed's New Auction System.
I explained yesterday why the Fed might substantially lower the discount rates. Essentially, no bank wants to lend out its capital (because it can’t), so the Fed as a lender of last resort (which it really shouldn’t be and can’t) is the only entity willing to lend (the only entity willing to create credit out of thin air and devalue the dollar).

But all in all, there is a stigma attached to borrowing from the Fed through the discount window: the banks have to disclose it and it illustrates severe financial weakness to their shareholders and depositors. For example, one source of liquidity that banks and companies like Countrywide (CFC) have been using is the Federal Home Loan Bank system where they don’t really have to tell anyone. This has saved the banking system so far but is tapped out.

So the Fed is considering a “new auction system”. Essentially, what the Fed is doing is taking the stigma away from the discount window--the Fed will lend directly to banks and the banks don’t have to tell anybody. Theoretically, the Fed could make these quiet loans for indefinite periods, thus giving banks more permanent capital (it’s really credit, but banks call it capital).

I have a feeling the Fed moved less yesterday than expected because foreign investors (foreign central banks) were crying foul. A bigger move would further deteriorate the dollar and thus their investments in the dollar. It would also hurt their exports. They are getting pretty tired of this game and trade pressures are building.

The Fed knows that higher stock prices are important to reflate since 90% of global liquidity is dependent on high asset prices as collateral. Thus they are desperate to finance banks’ collateral values. How to do that? The only way is to lend directly to them.

The plan won’t work. Under the repo/fractional reserve system the debt can be hidden because it is spread out among many banks. Tthe Fed lending $10 billion (and thus their balance sheet rising by $10 billion) will turn into $500 billion as other banks lend that money out and only keep a fraction of it for themselves. This is not working. Under the “new” plan the Fed will lend directly to each bank. If they want to create $500 billion of new credit the Fed’s balance sheet will increase $500 billion.

This will be obvious to foreigners just like a big cut in the discount rate. This is why gold is up this morning in response to this “new” plan which is really just a hidden discount rate cut: if the Fed is willing to pervert its balance sheet to this extent the dollar will fall.

And gold (in dollars) will go up.
I agree with Mr. Practical that this plan will fail. And here I am a couple hours later now in Baltimore, and I see Washington Mutual (WM) down another 6% to a new 52 week low, Bank of America (BAC) is off 3.7%, Citigroup (C) is off another 5% and countrywide financial (CFC) is off 7%. The entire financial sector is getting hammered here in spite of the initial euphoria.

I do not know where stocks will close today or this month, but this plan does nothing to address capital impairment. The problem is not liquidity the problem is solvency. All the Fed is providing with this maneuver is liquidity. What is needed is capital. Every company above (and lots more too) are capital impaired. The Fed's magic wand is simply out of magic.

Mike "Mish" Shedlock
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