The Fed Invents a New Trick

by Michael A. Nystrom, BullNotBull.com | March 12, 2008

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Prior Tuesday's monster 416-point Dow rally, global markets - not just those in the US - were panicked, possibly on the verge of a crash. US financial stocks were the primary focus of the fear. Monday, before the Fed's latest action, bank & financial stocks were in the grips of mini-crashes of their own. The XLF was down 4%, Citibank (C) down 6%, Leman Bros. (LEH) down 7%, Bear Stearns (BSC) down 11%, Freddie Mac (FRE) and Fannie Mae (FNM) down 11.5% and 13%, respectively. And these were just single day (3/10/2008) moves! Measured from their 52-week highs to Monday's lows, the declines for these financials have been brutal: XLF down 39%, C down 65%, LEH down 48%, BSC down 62%, FRE down 76%, and FNM down 74%. Clearly, the financials weren't anticipating a crash - the crash had already occurred. 

Furthermore, global markets had lost confidence in the Fed. The TIPS market was indicating that the Fed had completely lost control of inflation. The dollar was caught in a downward spiral. The opinion was that the Fed was cornered - there was no way it could raise rates to protect the dollar, but lowering rates further risked even more inflation. 

The Fed Invents a New Trick

From this no-win situation, the Fed seemingly pulled a rabbit from a hat. The news, as it is gushingly told, is that the Fed has acted decisively to inject liquidity into the faltering financial system by loaning $200 billion worth of Treasuries - securities as good as cash - in exchange for mortgage backed securities. The implication is that banks that are loaded down with toxic, faltering, MBS's can just trade them in for Tbills. That's basically how I heard the news described on CNBC today, between the oohs & aahs at the record-breaking stock market rally. 

Gushing and hype aside, the real news is this: Today the Fed announced that it would loan Treasury securities to primary dealers for a period of 28 days, in exchange for AAA-rated mortgage securities, at a discount. The first weekly auction will not take place until March 27th. 

What does it mean? It means the Fed is expanding its role as a pawnbroker. Banks can bring their crappy loans in to the Fed and exchange them for risk-free Treasuries for a few weeks until they (the banks) can hopefully get back on their feet. But like with all pawnbrokers, there are a few caveats: The exchange won't be one-for-one; banks will have to take a haircut (discount) on their crappy loans. How much? That part hasn't been worked out yet. Oh, and the loans can't be that crappy. They've got to be AAA-rated paper. The banks will have to leave the super crappy toxic stuff at home. The Fed doesn't want that and that window isn't open, yet. Every 28 days the loan will have to be renewed, and seeing that the Fed is a bank, fees will most certainly apply. 

So what's the big deal? 

The Fed is trying to lubricate credit markets that have become sticky of late because trust has broken down. Banks don't even trust AAA rated paper, By stepping as lender of last resort, the Fed is trying to ease fears and get markets to act more "rationally" and "normally." (But who's to say they're not acting rationally now?) 

Will It Work?

Will the Fed's new plan work? Has crisis been averted? So far, so good if that 416 point rally is any indication. Confidence has been restored, at least for a day, spreads are coming down, and even the US dollar had a smart rally. But will it work in the long run? 

Hmmm... Oil just hit a new high near $110. It is said that the real housing crisis - the one where people are getting thrown out of their foreclosed homes - continues to worsen and is causing "a drop in cities' revenues, a spike in crime, more homelessness and an increase in vacant properties," according to this article. My local paper had a front page headline today that screamed, "Many more going bankrupt." It begins, "Bankruptcy filings have surged 22 percent in Massachusetts this year, as more people are unable to afford their rising mortgage payments or refinance their homes to pay bills, according to court filings and bankruptcy attorneys." And is it ironic to anyone but me that the so-called "safest" securities in the world, those that are considered "risk free" are US Treasuries? Mind you, Treasuries are the debt of a nation that has not properly balanced its budget in 40 years, is $9 trillion in debt, mired in unwinnable wars and is the issuer of a crashing currency? If it were anyone but the US, would these securities still be called "risk free?" 

So, no I don't think the Fed's latest plan will "work." This site isn't called Depression2 for nothing. The Fed's plan is a band-aid so that the financial de-leveraging might take place in an orderly, rather than disorderly fashion. 

How the Fed Affects Our Market Plan

If you've been following along with our plan to short the Dow, you should have sold the DOG position today when market traded back up into its range. 

I cannot stress enough that markets are completely unpredictable and traders must therefore limit risk and not get overextended. This is why we're trading with the modest position and the tight stop. We had a good setup and we swung at a pitch. It didn't work out. No big deal. We didn't lose much, and we're regrouped, ready for the next opportunity. Now it is back to watching how the market behaves within its new, expanded range. 

If you think that sucks, think of it like this: In 2007, David Ortiz had 549 at bats, and struck out 103 times. Each time he swung and missed, he simply accepted that it was part of the game. He didn't let it bother him or hinder him from his true goal. If he got bent out of shape with every strike, he never would have gotten 182 hits for a .332 average. 

I've just finished reading Michael Covel's excellent book titled The Complete Turtle Trader which is a fascinating account of Richard Dennis' Turtle Traders experiment in the 1980's. If you're serious about trading, you should read this book. 

In the mean time, it wouldn't be a bad idea to take advantage of the calm to prepare for the second great depression. 

Copyright © 2008 Michael A. Nystrom
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