So, the Fed and the ECB are now both taking dodgy mortgage debt as collateral against loans. One wonders how closely these deposits will be checked for value or will the western banks end up in the same boat as the Japanese financial institutions from the early nineties sitting with huge unrealised losses on 20-30 year loans being slowly amortised away. This scenario sounds fine until dealers remember that Japanese institutions could not borrow at market rates for many years as banks refused to increase credit lines. Where European and Americanís had access to funds at sub-Libor rates the likes of Nomura, Mitsubishi and Diawa had to pay Libor plus 150bpís and more.
This move shows up in sharp relief the inactivity of the Bank of England last autumn when they refused to accept good quality Northern Rock mortgage collateral. The lemming like following of the Fed shows how ineffective our central bank has become when coming up with original solutions to problems. With one of the rotting planks of financial stability being propped up one wonders if this will really make much difference or will another worm invested scenario rear its head. The last injection of liquidity did nothing to ease the credit crunch as financial institutions merely used the government largesse to bolster their own weak lending book and still refused to unlock the freeze on lines to other borrowers (as was shown with Carlyle and Pelaton over the last week or so). It remains to be seen whether this latest pool of easy money will be any different.
The problem for the central banks is that they (and to be honest, every single person in the capitalist society) cannot afford a single one of the major lenders to drop a brick. All the lenders are so intertwined with long term lending deals that if one goes then many may follow. Once Northern Rock got into difficulties the government was forced to act because otherwise all of Northern Rockís mortgages would have had to be repaid or sold off en-bloc to another lender. At that time nobody had the spare £100bn odd available on their balance sheets to take it on (even at fire sale prices). This, in an extreme scenario, could have lead to ten of thousands of houses being put on the auction block as mortgages were called in.
As the Japanese discovered, having virtually zero interest rates does not mean that your economy will necessarily grow if your financial institutions are so crippled that they are unable to lend aggressively. The country has been in a disinflationary environment for some 18 years which is the fear stalking the corridors of Wall Street and Washington. The Bank of Japan debt levels make the US deficit appear very small potatoes indeed. Their experience of what happens when the central banks start to have to prop up the banks in this fashion will create the fear that the Fedís initial $200bn is just the start of something very nasty indeed.
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'Finance Lesson from Japan' edited by SD, updated 12-Mar-08
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