Why the Fed's Latest Rescue Effort is Doomed

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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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About the Author

Keith Fitz-Gerald has been the Chief Investment Strategist for the Money Morning team since 2007. He's a seasoned market analyst with decades of experience, and a highly accurate track record. Keith regularly travels the world in search of investment opportunities others don't yet see or understand. In addition to heading The Money Map Report, Keith runs The Geiger Index, a reliable, emotion-free guide to making big money and avoiding losses, and Strike Force, which aims to get in, target gains, and get out clean. In his weekly Total Wealth, Keith has broken down his 30-plus years of success into three parts: Trends, Risk Assessment, and Tactics – meaning the exact techniques for making money. Sign up is free at totalwealthresearch.com.

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  1. Attorney Canavalli | December 1, 2011

    This is the beginning of inflation in our economy.

  2. John Burnette | December 1, 2011

    Perhaps it's easier not to think of Stocks rising in value. Perhaps it's easier to think that the value of the federal reserve note was just devalued in one big jump – so the stock prices adjusted accordingly.

    But Bernard Von Nothaus is still going to jail, right? It's a wonderful world we live in…

    I've just GOT to remember where I left that pitchfork….

  3. Phil Rourk | December 1, 2011

    The immediate problem in much of Europe appears to be finding a way to roll over/extend the maturities of a lot of sovereign debt. Isn't what the Bernank is really up to another incarnation of the secret lending program recently revealed through the Bloomberg suit, in which the Fed lent out hundreds of billions to the banks at rates below 1%, SO THAT THEY COULD PUT THAT MONEY RIGHT INTO US TREASURIES, thereby helping to finance TARP and all the other bailouts while providing the banks with about $13 BILLION in quick profits to cover other losses and strengthen balance sheets. What's the spread between the 50 basis points our Fed will be charging European central banks and other lenders to banks with significant sovereign exposure and the kinds of rates currently having to be paid by European treasuries? Even France, not to mention Italy and Spain. Question is, will it be enough? Will the US public stand for it, if the Fed is forced to disclose the magnitude of the proposed operation?

  4. brian morgan | December 1, 2011

    The Fed's most recent foray into the global monetary crisis, may not be as lame-brained as you think… if you consider the state of the economy in the US.. the amount of government borrowing… all the rounds of QE… all of the states which are more or less bankrupt… including the US government and the very real danger that the dollar will cease to be the world's currency reserve… how do you fix this pronblem??…easy .. you intertwine the dollar so inextricably with all of the other major currencies of the world { particularly the euro} and we then have a situation where it would be unthinkable to allow the dollar to implode… so don't be so quick to to write off this scheme as "token" or "lame-brained"…it may not be what they say it is but it could certainly be a very sneaky way to protect the dollar

    • Chuck Franco | December 1, 2011

      Agreed, it is extremely important to keep the US Dollar intertwined with the rest of the world so as to keep our way of life functioning smoothly. However, I'm not so sure that this is merely putting off the inevitable given the paralysis shown by the domestic "leaders", public and private, in coming to grips with the problems in the USA on an even basis for all.

    • Jeff Pluim | December 1, 2011

      Brian Morgan, I was thinking the exact same thing as I read Kieth's article. The Americans had to do something to keep the yuan from overtaking the world markets. The Chinese have been making yuan denominated trading agreements with various governments around the world and it seriously threatened the USD current reserve currency status. This was a stroke of genius. I agree with Kieth that it may not, and probably will not, help the markets in the long run, but it makes it a lot harder for the Chinese to crack the European market with any yuan denominated trading agreements. But I will still be tightening up my trailing stop losses and going short on some of the biggest gainers in this current rally.

    • dodo | December 2, 2011

      Anything's possible, but I doubt that very much. The Fed, being the criminal enterprise it is, is trying and looking after their banking syndicate, period! The Fed tried to prolong and keep the world banking syndicate from going down for good, but they could only buy some time — the big banks are all insolvent! The Fed is a big-time criminal counterfeiter; it just created $ out of nothing; and we all should be going after the banking criminals and their conniving and corrupted affiliates(politicians, regulators, etc.).

  5. bo sandberg | December 1, 2011

    excellent – and very clarifying!! agree!!!

  6. Lok Chong | December 1, 2011

    You could be right Brian, the FED is creating a situation for the USA to be another "Too Big to fail". It could well turn out that the FED and the other Central Banks of the G7 (the Go-together 7) are locking themselves together to face the unprecedented fast unfolding financial tsunami onslaught. Does anyone know how/where a stretch to the limit rubber-band will end up when it breaks?

  7. CHRISTOPHER MADDOX | December 2, 2011

    This is another step towards the world currency. In fact, it already exists as SDRs.

  8. sane khan | December 2, 2011

    thanks

  9. GEORGE FRANCO | December 7, 2011

    I have finallly found an honest gutsy newsletter!! Thanks.

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