As an indication of how bad the The Banking Liquidity Crisis is, the Federal Reserve held the first emergency weekend meeting in 30 years to try and save investment bank Bear Stearns, which was in danger of going bankrupt thanks to bad mortgage-backed securities and other collateralized debt obligations. Without Fed intervention, the failure of Bear Stearns could have spread to other over-leveraged investment banks, including Merrill Lynch, Lehman and Citigroup.

Why couldn't the Fed wait until Monday? On Friday, Bear Stearns was worth $3.5 billion even after the announcement that it was to be bought by JP Morgan Chanse. The rescue of Bear Stearns was necessary after Moody's downgraded its subprime mortgage debt. However, over the weekend JP Morgan Chase realized Bear Stearns was only worth $236 million - 1/5 the value of its headquarters building. In effect, the company is worthless.

However, thanks to its over-leveraged position, the value of its outstanding trades is $10 trillion. Therefore, JP Morgan Chase needed a $30 billion loan guarantee from the Fed before it would agree to the deal. (Source: CNNMoney, Bear Stearns Hit 5-Year Low, March 10, 2008; The Economist, JP Morgan Chase takes over stricken Bear Stearns, 3/18/08; Mish's Global Economic Trend Analysis, Fed Fails to Halt Debt Meltdown, 3/18/08)

In its weekend meeting, the Fed also lowered the primary credit rate to 3.25%. These actions are another way the Fed is trying to keep liquidity in the financial markets. Last week, the Fed announced will loan $200 billion in Treasury notes to bail out bond dealers who are stuck with 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. However, this program won't start in time to help Lehman, hence the emergency weekend meeting. (Source: Financial Times, Fed fights on with $200 billion facility, 12/12/07)

What It Means to You

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.

The problem has become one 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 for the banks to sort things out by temporarily taking on the bad debt itself. This may work, unless the Fed itself gets stuck with the bad debt. If that happens, it will cost more than the Savings and Loan Crisis, which "only" cost the taxpayers $124 billion.

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