Bernanke and the Banks.

Bernanke has been getting in some quarters pretty rough treatment. That he is doing so is really quite unjust, as the problem was not of his making, yet, the requirement to find a solution has fallen to him.

The rate cuts that we have seen from the Fed over the last 6mths, what are they about?

*They are not related to inflationary pressures
*They are not for the economy generally
*They are not for the stock market in specific

*They are for the Banks.

The banks got badly caught in the current downdraft in sub-prime mortgages, and increasingly in other mortgages that were granted under very lax lending standards. Their exposure was large. [see chart]

As the default rate climbed, so their capital flew out the door. All of this is old news. Therefore the answer to the problem lies in looking how banks make money and lose money.

Banks in essence borrow short, and lend long on the yield curve. Thus when the yield curve is inverted, banks potentially get hammered. When there is a steep curve, banks can make money. The yield curve first inverted for this particular crisis, at the beginning of 2006, and stayed flat or inverted all the way through 2006 and all of 2007, where the markets imploded towards December.

Since then, the story has been rate cuts.

The reason is extremely simple. The banks can be saved. The banks borrow at the Repo rate, and purchase US Treasury securities further along the curve, generating a positive spread, and guaranteed earnings.

Now, there is always a risk that interest rates at the short end could rise without the Banks knowing. There is also an Easter Bunny and Santa Claus.

Now that the dirty laundry is out of the closet, and the various governmental agencies realise just how insolvent the major banks actually are, the bailout is in full swing.

Rates, if they rise, will only rise when the US financial system is safe. Not before. If and when they do rise, the banks will have been informed prior, so that they can ensure their Balance Sheets are ready.

Of course this is not the first time that this has happened. The 1990-1991 recession had exactly the same solution to bail out the banks caught in a real estate downturn.

Who are some of the biggest names currently in trouble?
Lets look at a list of Fed approved Primary Securities Dealers.

List of the Primary Government Securities Dealers Reporting to the Government Securities Dealers Statistics Unit of the Federal Reserve Bank of New York

BNP Paribas Securities Corp.
Banc of America Securities LLC
Barclays Capital Inc.
Bear, Stearns & Co., Inc.
Cantor Fitzgerald & Co.
Citigroup Global Markets Inc.
Countrywide Securities Corporation
Credit Suisse Securities (USA) LLC
Daiwa Securities America Inc.
Deutsche Bank Securities Inc.
Dresdner Kleinwort Wasserstein Securities LLC.
Goldman, Sachs & Co.
Greenwich Capital Markets, Inc.
HSBC Securities (USA) Inc.
J. P. Morgan Securities Inc.
Lehman Brothers Inc.
Merrill Lynch Government Securities Inc.
Mizuho Securities USA Inc.
Morgan Stanley & Co. Incorporated
UBS Securities LLC.

Recognise any of the names on the list of banks that are currently struggling?
Think the Fed will let them fail?

Once the Banks can clean up their Balance Sheets, which will take some time as the sheer stupidity of the various CEO’s involved has virtually destroyed many of them, then the final touches will be applied via a rising stock market valuation on their respective common shares, which provide capital to the banks.

In the interim, the US$ will just be left to fend for itself, thus inflation will quite possibly get far worse yet, the economy will stagnate or move into deep recession as there will be little or no credit creation from the banks until they are re-capitalised, and the stock market…might start to rise.

When it eventually becomes clear that the Fed’s first aid and ER procedures are bringing the patient back, and that the financials as a sector are going to rise on short covering, value, momentum based investors, there could be a general market rally.

Make no mistake, banks should have failed, banks are largely insolvent and totally existing on the whim of the Fed, but, some are just too big to fail.