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Monday, March 17, 2008 2:51 AM

Fed Fails To Halt Debt Meltdown

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In yet another attempt to to halt the global debt meltdown now in progress, the Fed Lowered the Discount Rate and Expanded Lending to Primary Dealers in an emergency weekend meeting.

In its first weekend emergency action in almost three decades, the central bank lowered the so-called discount rate by a quarter of a percentage point to 3.25 percent.

The Fed also will lend to the 20 firms that buy Treasury securities directly from it. In a further step, the Fed will provide up to $30 billion to JPMorgan Chase & Co. to help it finance the purchase of Bear Stearns Cos. after a run on Wall Street's fifth-largest securities firm.

Opening up lending to firms other than commercial banks represents a shift in the Fed's 94-year history.

"It is a serious extension of putting the Federal Reserve's balance sheet in harm's way," said Vincent Reinhart, former director of the Division of Monetary Affairs at the Fed and now a scholar at the American Enterprise Institute in Washington. "That's got to tell you the economy is in a pretty precarious state."

"We learned that Bear Stearns's balance sheet on close examination was worth a 10th of its market value," said Reinhart.

"Clearly, the Fed is trying to provide more liquidity to prevent a more vicious cycle and race to the bottom," said Gary Schlossberg, senior economist at Wells Capital Management in San Francisco, which oversees $200 billion. "The problem is there's so much concern about credit quality that now there are solvency issues, and it's something the Fed has a more difficult time dealing with."

Yesterday's events are "nothing like the 1970s, which was about fighting inflation," said David M. Jones, a former New York Fed economist. "This is fighting a negative, self-reinforcing process" of sliding collateral values, tighter bank credit and weakening of economic conditions, he said.
Nothing Like The 70's

Nothing like the 70's is right. Here is proof.

Yield Curve As Of March 16, 2008

click on chart for sharper image

Are short term interest rates at 1.16% (and falling) indicative of stagflation? Certainly not. You can kiss stagflation theories goodbye on the basis of the above chart. Somehow the myth persists.

Primary Dealer Credit Facility

Here is the Federal Reserve press release announcing the Primary Dealer Credit Facility.
The Federal Reserve has announced that the Federal Reserve Bank of New York has been granted the authority to establish a Primary Dealer Credit Facility (PDCF). This facility is intended to improve the ability of primary dealers to provide financing to participants in securitization markets and promote the orderly functioning of financial markets more generally.

The PDCF will provide overnight funding to primary dealers in exchange for a specified range of collateral, including all collateral eligible for tri-party repurchase agreements arranged by the Federal Reserve Bank of New York, as well as all investment-grade corporate securities, municipal securities, mortgage-backed securities and asset-backed securities for which a price is available.

The PDCF will remain in operation for a minimum period of six months and may be extended as conditions warrant to foster the functioning of financial markets.
Facility Failures
  • The TAF (Term Auction Facility) failed to restore liquidity.
  • The TSLF (Term Securities Lending Facility) failed to restore liquidity. See The Fed's Swap Meet for more on the TSLF.
  • The PDCF (Primary Dealer Credit Facility) will be the next "facility" to fail.
Bear Stearns Implodes

The Fed's emergency weekend actions above are all part of a failing effort to contain the fallout from the demise of Bear Stearns. On Friday Bear Stearns was worth $30 a share. Sunday evening Bear Stearns was worth $2 a share as PUT Buyers Celebrate Bear Stearns' Demise.

However, to get JPMorgan to commit to the deal, the Fed has agreed to fund up to $30 billion of Bear Stearns’ less liquid assets.

The stated book value of Bear Stearns last Friday was $80 billion. My quick math shows the actual book value of Bear Stearns was as little as -$28 billion taking into account Fed guarantees. That should put some new meaning to the term "Marked To Market".

Think all that debt on the books of Lehman (LEH), Morgan Stanley (MS), Goldman Sachs (GS), Citigroup (C), Merrill Lynch (MER), Bank of America (BAC), etc., is worth what is claimed? Think again. More revaluations are coming.

Mike "Mish" Shedlock
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