Paul Krugman explains the problems financial markets are facing, and why he is doubtful that the Fed's interventions will be enough to prevent further problems:
The Face-Slap Theory, by Paul Krugman, Commentary, NY Times: Friday’s employment report ... was bad news. But it was actually less disturbing than what’s going on in the financial markets. ... To understand the gravity of the situation, you have to know what the Fed did last summer, and again last fall.
As late as August the favorite buzzword of financial officials was “contained”: problems in subprime mortgages, we were assured, wouldn’t spread...
Soon afterward, however, a full-fledged financial panic began. Investors pulled hundreds of billions of dollars out of asset-backed commercial paper, a little-known but important market... This de facto bank run sent shock waves through the financial system.
The Fed responded by rushing money to banks, and markets partially calmed down, for a little while. But by December the panic was back.
Again, the Fed responded by rushing money to banks, this time via a new arrangement called the Term Auction Facility. Again the markets calmed down, for a while.
But again, the respite was only temporary. Last month..., the $300 billion market for auction-rate securities..., suffered the equivalent of a bank run. ... Even Fannie Mae and Freddie Mac, the giant government-sponsored mortgage agencies long regarded as safe places to put your money, are now having trouble attracting funds.
One consequence of the crisis is that while the Fed has been cutting the ... Fed funds rate — the rates that matter most directly to the economy, including rates on mortgages and corporate bonds, have been rising. And that’s sure to worsen the economic downturn.
What’s going on? ... JPMorgan Chase ... described what’s happening as a “systemic margin call,” in which the whole financial system is facing demands to come up with cash it doesn’t have. (A financial joke making the rounds, via the blog Calculated Risk: “Who is this guy Margin that keeps calling me?”)
The Fed’s latest plan ... is — as ... interfluidity.com cruelly but accurately describes it — to turn itself into Wall Street’s pawnbroker. Banks that might have raised cash by selling assets will be encouraged, instead, to borrow money from the Fed, using the assets as collateral. In a worst-case scenario, the Federal Reserve would find itself owning around $200 billion worth of mortgage-backed securities.
Some observers worry that the Fed is taking over the banks’ financial risk. But what worries me more is that the move seems trivial compared with the size of the problem: $200 billion may sound like a lot..., but when you compare it with the size of the markets that are melting down — there are $11 trillion in U.S. mortgages outstanding — it’s a drop in the bucket.
The only way the Fed’s action could work is through the slap-in-the-face effect: by creating a pause in the selling frenzy... And to be fair, that has worked in the past.
But slap-in-the-face only works if the market’s problems are mainly a matter of psychology. And given that the Fed has already slapped the market in the face twice, only to see the financial crisis come roaring back, that’s hard to believe.
The third time could be the charm. But I doubt it. Soon, we’ll probably have to do something real about reducing the risks investors face.
A plan to restore the credibility of municipal bond insurance would be a start... I also suspect that the feds will have to get explicit about guaranteeing the debt of Fannie and Freddie, which really are too big to fail.
Nobody wants to put taxpayers on the hook for the financial industry’s follies; we can all hope that, in the end, a bailout won’t be necessary. But hope is not a plan.