Fed $200 Billion Loan Probably Won't Help

Yesterday, the Federal Reserve announced it will loan $200 billion in Treasury notes to bail out bond dealers who are stuck with mortgage-backed securities and other collateralized debt obligations that they can't resell on the secondary market. The secondary market for these debt products has dried up as a result of the Subprime Mortgage Crisis.

Since no one knows who has the bad debt, and how much is out there, all buyers of debt instruments have become afraid to buy and sell from each other because no one wants to get caught with the debt on their books. Yesterday's announcement is another way the Fed is trying to keep liquidity in the financial markets.

However, the problem is not just one of liquidity, but also of solvency. Banks and other lenders are playing a huge game of musical chairs, hoping that no one gets caught with more bad debt. The Fed is trying to buy time by temporarily taking on the bad debt itself. It is protecting itself by only holding the debt for 28 days, and only accepting AAA rated debt.

On the other hand, the Fed may only be prolonging the inevitable, because the situation won't be resolved in 28 days. That's because, ultimately, financial institutions will have to continue to write down the bad debt and take their losses. The Fed's actions may only be buying time, unless the Fed itself gets stuck with the bad debt. (Source: Financial Times, Fed fights on with $200 billion facility, 12/12/07)

What It Means to You

If the Fed gets stuck with the bad debt, then this will cost more than the Savings and Loan Crisis, which "only" cost the taxpayers $124 billion.

However, we aren't there yet. The uncertainty, unfortunately, will probably continue to trigger continued stock market declines and possibly even a recession.

• The Federal Reserve and the 2007 Banking Liquidity Crisis
• A Primer on Current Federal Reserve Interest Rates
• Recession, and Depresssion - Definition, Causes and How It Affects You