Friday, December 19, 2008

The Fed - Why it will Fail, How it will Fail

Via Naked Capitalism, we learn that the Fed will now lend to hedge funds:

The Fed said on Friday it would offer low-cost three-year funding to any US company investing in securitised consumer loans under the Term Asset-backed Securities Loan Facility (TALF). This includes hedge funds, which have never been able to borrow from the US central bank before, although the Fed may not permit hedge funds to use offshore vehicles to conduct the transactions.

I have nothing against hedge funds per se, but this is sure to raise flags for members of Congress, as well as the public, especially after the Madoff fraud. Why then is the Fed so keen on doing it? Because it is now in exactly the same situation with credit-card debt, as it was with housing debt a year ago. It failed with housing debt, and it will fail with credit-card debt. The latter has reached unsustainable levels, it can't go on. But the Fed refuses to accept this fact, because it needs and wants to keep the American consumer spending. The Fed simply doesn't understand what "unsustainable" means and hopes that by mere force of will (Bernanke's "We will not stand down") it can keep the waves from crashing or force the horse to drink. While Krugman has compared Wall Street to a Madoff-like Ponzi Scheme, the real Ponzi Scheme is now being run by the Fed.

So how will it end? By a classic rush-to-the-exits, in a crowded theater where someone has yelled "fire". The Fed is putting lots of illiquid assets on its balance sheet, which it won't easily be able to get rid of, should the original owners default. It is effectively borrowing short - massively - and lending long - massively. This works until it doesn't. It works, as long as there is confidence that it work. There is confidence that it will work, so long as the participants think everyone else has confidence that it will work. It stops working when enough people decide they don't want to lend short any more. The confidence evaporates, the Ponzi scheme gets blown, and the exits are swamped.

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