Why the Fed's Latest Rescue Effort is Doomed

According to the author of the article, the latest Fed rescue is a doomed effort and if anything, it is going to make things worse. Standard & Poor's also recently announced its downgrade of 15 of the largest banks in the world, making things even more troublesome.

December 1, 2011
By Keith Fitz-Gerald, Chief Investment Strategist
Money Morning

World markets got a nice tailwind yesterday (Wednesday) on news that the U.S. Federal Reserve is stepping into the fray along with other central banks to boost liquidity and support the global economy.

Of course it's nice to see stocks get a hefty boost, but to be honest I'd rather see them rising on real news.

Not that this isn't a good development in terms of stock values - but come on, guys. When things are so bad that the Fed has to step into global markets and bail out the other bankers in the world who can't wipe their own noses, we have serious problems.

Think about it.

The Fed is going to collaborate with the European Central Bank (ECB), the Bank of England (BOE), the Bank of Japan, the Swiss National Bank and the Bank of Canada (BOC) to lower interest rates on dollar liquidity swaps to make it cheaper for banks around the world to trade in dollars as a means of providing liquidity in their markets.

Put another way, now our government is directly involved in saving somebody else's bacon at a time when, arguably, we don't have our own house in order.

The Fed is cutting the amount that it charges for international access to dollars effectively in half from 100 basis points to 50 basis points over a basic rate.

The central bank says the move is designed to "ease strains in financial markets and thereby mitigate the effects of such strains on the supply of credits to households and businesses and so help foster economic activity."

Who writes this stuff?

Businesses are flush with more cash than they've had in years. The banks are, too. But the problem is still putting that cash in motion -- just as it has been since this crisis began.

From Bad to Worse

I've have written about this many times in Money Morning. You can stimulate all you want with low rates, but if businesses cannot see a reason to spend money to turn a profit, they won't. And there's going to be little the government can do to encourage them to spend the estimated $2 trillion a Federal Reserve report estimates they're sitting on.

Similarly, if banks cannot see a reason to lend with reasonable security that loans will be repaid, they won't. And there's nothing the central bank can do about it, either. Neither low interest rates nor low-cost debt swaps will change the fact that companies and individuals are shedding debt as fast as they can despite the cost of borrowing being almost zero.

If anything, the Fed's newest harebrained scheme is going to make things worse. Absent profitable lending, many banks are already turning to bank fees and - like the airlines that are widely perceived to be nickel-and-diming passengers - this is understandably irking customers. Many are changing banks as a result, further fueling a negative feedback loop.

At the same time, ratings agencies are lowering credit ratings on banks worldwide. Standard & Poor's, in particular, just hammered 15 of the biggest banks in Europe and the United States as part of a dramatic overhaul of its ratings criteria. Good move guys, but you are literally days late and trillions of dollars short.

The problem is that by hammering the likes of JPMorgan Chase & Co. (NYSE: JPM), Bank of America Corp. (NYSE: BAC), Well Fargo & Co. (NYSE: WFC), Goldman Sachs Group Inc. (NYSE: GS), Morgan Stanley (NYSE: MS), Barclays PLC (NYSE ADR: BCS), HSBC PLC (NYSE: HBC) and UBS AG (NYSE: UBS), among others, the ratings agencies have also just baked worse performance into the cake.

The reason is that for every ratings drop, banks need to have additional credit facilities and collateral on hand. That's why the compliance departments for big banks have been in overdrive recently. They can't refresh their disclaimers fast enough. The new ratings will trigger automatic changes in existing derivatives contracts, funding commitments, and borrowing arrangements.

Collateral Damage

Take American International Group Inc. (NYSE: AIG), for example.

Regulations allow firms with the highest credit ratings to enter swaps and other exotic derivatives contracts without depositing collateral with their counter-parties (those on the opposite side of the trade). When AIG was downgraded, the firm was instantly required to post collateral to the potential tune of $85 billion -- collateral it didn't have. That meant the U.S. government - i.e. taxpayers - had to create a special secured credit facility of the same amount. Whether you view that as a backstop or bailout is a matter of perspective.

That wasn't enough, though. As AIG's stock continued to weaken, and ratings were dropped further as the company's financial strength deteriorated, the government had to create additional facilities against which AIG ultimately drew $90.3 billion against a total of $122.8 billion as of Oct. 24, 2008.

Or, consider BofA. Downgrades impact BofA's derivatives contracts and will require the bank to put up more collateral in much the same way. At the same time, the downgrades could trigger termination provisions in the contracts that result in losses and ultimately further damage the already-struggling behemoth's liquidity.

As for how that affects your wallet, it's really pretty simple. Bank of America reported a third-quarter profit of $6.2 billion profit that was mostly accounting gains. A ratings cut could easily wipe that out as well as any future gains in the months ahead, depending on the extent of the resulting damage it triggers.

And that's part of the problem. Exactly how much damage lurks? There are more than $600 trillion in derivatives contracts that we know about. And there are potentially trillions more in collateral requirements that we still don't know about. These things are entirely unregulated -- and that's a huge part of the problem, even now.

Nobody knows what the impact will be, but we undoubtedly will find out. My guess is that it will be in the hundreds of billions, and that money has to come from somewhere.

Perhaps that's the real reason the Fed acted. Now that S&P has blasted the 15 biggest banks, the central bank is worried about the new updated ratings on the other 750 banks that S&P covers.

The bottom line: Don't misinterpret this rally as anything other than what it is at face value - a complete farce and nothing more than a globalform of QE3 even though it's not being called that.

A Look Ahead

Here are the things to watch:

The dollar is going to rally if the primary liquidity mechanism used remains dollar swaps. Gold will likely fall over the same time period. Oil will slip. And Treasuries will rise as traders come to terms with the real risks.

Then the real games will begin.

In the meantime, don't look a gift horse in the mouth. Be nimble. Harbor no illusions about what is happening. Capture profits as they're created and ratchet up your trailing stops if the rally gains legs.

The Fed has merely saved the day, not the system (and I'm echoing the legendary Jim Rogers here, who originally made similar comments directed at the ECB's actions during a CNBC interview on Oct. 17, 2011.).

The more drugs you inject into an addict, the more dependent he becomes on them. The Fed's actions are not a solution on anything more than a short-term basis.

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