The Federal Reserve arranged rescue of Bear Stearns in March has been widely credited as having stabilized financial markets. Stocks, especially financials, have performed very well since. The ensuing celebration has largely viewed these events as the Fed’s gift to the economy, and investors in particular. Caution: there is an old saying “Do not look a gift horse in the mouth.” The meaning is that if someone is willing to gift you a horse there might be something wrong with it, such as a lack of teeth. If that is the case the horse is doomed to starvation.
Let’s examine the Fed’s “gift horse”. The Bear Stern rescue was accomplished by the Fed changing the way it serves the financial system. One major change is that it opened the discount window for short term lending to investment banks. Previously the window was available only to traditional (commercial) banks, although the expansion of many of these banks into the investment arena had blurred the distinction between commercial and investment banking. For example, Bank of America, Wachovia and other super-regional banks have moved into some investment banking areas in the past several years. Now, however, investment corporations such as JP Morgan and Goldman Sachs can arrange short term financing directly by the Fed. This was not possible before March.
Another major change with the “gift horse” is the way the Fed allows the discount window to used. Traditionally, the securities traded through the window were U.S. Treasuries. These were the collateral used to secure the Fed loans to the banks. Now the Fed is accepting collateralized debt obligations (CDOs), including mortgage backed securities, in exchange for U.S. Treasuries. In other words, the toxic waste of the mortgage crisis is now being taken off the books of the investment banks and put on the books of the Federal Reserve.
Securities held by the Fed is what backs the value of the $818 billion of U.S. currency estimated to be in circulation. Because approximately 20% of the securities backing the value of this $818 billion is now comprised of CDOs of unknown value, the future value of the dollar is at risk. Of course, the value of the dollar is already down because of huge federal deficits and trade deficits. The debasing of the securitization of the dollar just adds another layer of burden weighing down the value.
The dollar is a fiat currency. This means it is a currency not backed by any hard physical assets, such as gold. The dollar has been the reserve currency of the world for several decades. However, since the end of the gold standard in 1972, the only backing of the dollar is “the full faith and credit of the U.S government”. The agent of the U.S. government for maintaining faith and credit is the Federal Reserve Bank. The securities held by the Fed are becoming increasingly suspect. For a few months in the spring of 2008 the Fed has “rescued” a floundering U.S. financial system. What will the consequences of this rescue be in the coming months and years? It is unsettling that in the history of the world there has not been a previous fiat currency that has survived. All historical fiat currencies have eventually collapsed to worthlessness. It is true that some fiat currencies have survived for a long time. An example is the currency of the Roman Empire, which survived for hundreds of years. In more recent times, fiat survival has been much shorter.
The possible salvation for this gloomy scenario is that the CDOs will prove to have value and will be returned to the books of the investment banks. In this case the securities held by the Fed will be restored to U.S. Treasuries. After all, Fed loans are temporary and short-term. The problem is that the value of the mortaged backed securities will not be worked out in the short term. The work out of variable mortgage resets will not be substantially completed for 2-3 years. The decline in the housing market (house values) may not be 50% complete. The lower house values fall, the higher the mortage default rate. So the question mark in the title will not be resolved for several years. Ask again in 2011.