Last week, it was a $200-billion cash-for-bond swap for the banks. This week, it was a $200-billion bond-for-bond swap for the big investment houses.
If they keep this up, pretty soon you'll be able to walk into any Federal Reserve bank and hock that diamond broche you inherited from Aunt Mildred.
Forget all that nonsense about the Bernanke Fed being too timid or behind the curve. The Fed has been more aggressive and more creative in using its limitless balance sheet — in effect, its ability to print money — than at any time in history.
The real action is on the credit markets, where for the third time since last summer, the price of bonds and other complex securities fell and rates rose on everything but Treasury bonds.
Over the previous month, there had been fresh signs the economy was sinking into recession: a slowing of the growth in corporate sales and profits, a decline in payroll employment and deterioration in the housing market. Deeper cracks began to appear in commercial real estate. And out of the blue, municipalities and nonprofit institutions found that they could no longer roll over their short-term debt on the auction-rate market.
But the real problem began in late February, as several of Wall Street's biggest investment banks prepared to close their books for the quarter and realized they were looking not only at big declines in profit from issuance of new stocks and bonds and fees from mergers and acquisitions, but also another round of writeoffs in the value of their holdings. The banks began to hunker down, instructing trading desks to raise margin requirements for hedge funds and other customers, requiring them, in effect, to post more collateral on their heavy borrowings.
Thus began a chain reaction in which hedge funds began selling what they could — largely mortgage-backed securities guaranteed by Fannie Mae, Freddie Mac and Ginnie Mae — to raise the cash to meet their new margin calls. That wave of forced selling drove down the price of those bonds, which prompted more forced selling.
Among those caught up were hedge funds run by such blue-chip names as KKR and Carlyle Group, along with Thornburg Mortgage. News of their troubles swept through Wall Street, as did rumors that Goldman Sachs was about to post big losses and Bear Stearns was about to run out of cash. Lehman Brothers said it would lay off 5 percent of its staff in what was viewed as the start of a consolidation that would kill 20 percent of the jobs on Wall Street. Analysts began to warn that financial sector losses from mortgages, commercial real estate, failed takeover loans and other bad gets could reach $1-trillion.
The Fed hoped that by injecting $400-billion of liquidity, it could help restore the credit markets. For it is only when bank lending and credit markets have returned to normal, say Fed officials, that the beneficial effect of their interest rate cuts can be transmitted to the economy.
It's anyone's guess how long this credit crunch will last, but the chances are that we'll have several more market meltdowns and Fed rescues before it's over, probably in the fall. Until then, the dollar will continue to get hammered and stocks will continue their fitful decline. And if the last two financially induced recessions are any guide, it will be well into 2009 before the economy hits bottom, followed by a couple of years of slow growth and "jobless" recovery.