And I quote...

From the most recent speech of Fed governor Mishkin...

"Our understanding of the sources of systemic risk immediately suggests three general principles for operating as an effective lender of last resort: (1) restore confidence in the financial system by quickly providing liquidity, (2) limit moral hazard by encouraging adequate prudential supervision, and (3) act as a lender of last resort infrequently."

Perhaps I am being overly critical of the role of central banks, but I would like to point out that The Federal Reserve and other central bankers around the globe have not been following their own standards.

1) While they have injected billions in liquidity, it remains to be seen whether confidence has been restored. The $40 billion Canadian ABCP market is still locked up. UK banks without credit exposure to US Subprime are failing and depositors are running for the exit. The largest deposit banks in the US (Citi, BoA, Wachovia, etc) have borrowed $500 million apiece to funnel to their investment banking arms. What confidence?

2) The last several Fed cuts in the interest rate have fueled asset bubbles rather than encourage adequate prudential supervision. In fact, it can be argued that had Greenspan not cut interest rates to 1% and held it there for too long, we would not be currently mired in a housing asset bubble of epic proportions.

3) Infrequent - If we take the word at its literal translation, it would mean that the lender of last resort should not make 'frequent' forays into the credit markets. In the past several weeks, central bankers have injected billions - billion with nine trailing zeros - into the credit markets. And every week, they have to lend more. Just this week, the US Federal Reserve has lowered the collateral standards to include mortgage securities.

So what does this all mean?

In my opinion, either the central bankers are stupid, or they are trying desperately to prop up the markets in hopes that the gummed up markets will loosen themselves in time. I prefer to believe the latter.

If the credit markets are still locked up, then we can reasonably expect the next several months to be extremely volatile. Either the other shoe falls, or things calm down enough for normal lending to occur. In either scenario, it will be an interesting period indeed.

-Jason

The Fed's No-Win situation

It seems to me, no matter what the Fed decides to do tomorrow (lower short term rates by 0/25/50 bps), the stock market is bound to go lower.

Let say the Fed does nothing or only lowers the rate by 25 bps. Market participants will hammer the stockmarkets worldwide in response to what they view as an inadequate action by the Fed to rescue a clearly ailing US economy. The 'Greenspan put' (the idea that the Fed will come to the rescue of the economy at any time) will be laid to rest at last and the markets could be looking at a prolonged decline until the next catalyst appears.

If on the other hand, the Fed lowers the rate by 50 bps or more, markets will rally in the short term. But this will only be temporary. If the data driven Bernanke Fed decides to make such a drastic reduction in the overnight rate, then things must look bad indeed. If we go back to economics and the business cycle, when interest rates start declining, it is an indication of a top or a recession. Stocks do not go up until the later stages of a recession, and we are far from that point.

Remember, with crude trading near $80, inflationary pressures are still present. Also, the majority of ARMs do not reset until early 2008. There will be more pain before things look better.

-Jason

Disclaimer

This blog is a personal blog for me, Jason Chen, to share my views on the world markets with my friends, family, and anyone else who wish to subscribe. The big disclaimer is that I am not - in any shape or form - suggesting anyone follow my investment strategies. If anyone does try to emulate my investment strategies, they do so entirely at their own risk.

- J