The Federal Reserve is in a panic and is searching for extra ordinary means to deal with liquidity crisis. Quietly, insiders are perusing an obscure paper by Fed staffers David Small and Jim Clouse. It explores what can be done under the Federal Reserve Act when all else fails. Meaning how can they lend money to banks, businesses, and John Q Citizen when the retail banks won’t. Section 13 (3) allows the Fed to take emergency action when banks become "unwilling or very reluctant to provide credit". A vote by five governors can - in "exigent circumstances" - authorize the bank to lend money to anybody, and take upon itself the credit risk (Ambrose Evans-Pritchard).
The credit crisis is now in its fifth month with the Federal Reserve still grappling with the problem which it seems to be unable to handle. US Federal Bank Chairman Ben Bernanke is keeping his word to "drop money from helicopters to fight deflation" and is stepping up the deluge of cash being injected as the Associated Press reported Friday
"The Federal Reserve announced Friday that it is increasing the amount of money available to banks through the new auction process it created to ease the nation’s severe credit squeeze by 50%."
This comes after the fed has dropped the overnight discount rate (http://www.investopedia.com/terms/d/discountrate.asp) several times since August while also decreasing the Fed Fund rate (http://www.investopedia.com/terms/f/federalfundsrate.asp) but it just does not seem to be doing the trick. The issue is the psychology of liquidity which is confidence. When investors are optimistic, confident remains high and liquidity expands. However, when optimism is taken over by fear confidence suffers and thus liquidity contracts (Elliotwave International, 2007 EWFF).
The VIX is a widely used measure of market risk and is often referred to as the "investor fear gauge". The daily price and open interest in VIX options have been rising which implies rising fear. The picture painted is frightening! It infers no matter what the Federal Reserve does as it relates to adding liquidity it will be useless because of the markets fear and lack of confidence.
The Subprime debacle is just the beginning of this great economic tragedy that is about to explode. The lack of confidence has hit throughout the banking system. We now have a situation where banks are hording cash because there assets have shrunk, do not know who will be able to repay loans, and they fear a run on the bank. This fear has brought the global financial system to a virtual halt.
The Federal Reserve is in a panic and is searching for extra ordinary means to deal with liquidity crisis. Quietly, insiders are perusing an obscure paper by Fed staffers David Small and Jim Clouse. It explores what can be done under the Federal Reserve Act when all else fails. Meaning how can they lend money to banks, businesses, and John Q Citizen when the retail banks won’t. Section 13 (3) allows the Fed to take emergency action when banks become "unwilling or very reluctant to provide credit". A vote by five governors can - in "exigent circumstances" - authorize the bank to lend money to anybody, and take upon itself the credit risk. This clause has not been evoked since the crisis began in August. However I would expect it sometime in 2008.