Flash Update: The Continuing Financial Crackup

Precarious. Ominous. Dismal. Woeful. Vulnerable. Perilous. These are just a few of the adjectives that describe the current condition of the United State’s financial markets. The crisis that I wrote about in this column last Dec. 27 has continued to deteriorate. The conclusion that the Federal Reserve would sacrifice the dollar in the attempt to avert a total breakdown of our credit markets remains valid.

Gold now trades for over $1000 an ounce. (This is concurrent with the latest monthly Consumer Price Index report of zero inflation—a jarring juxtaposition likely to erode whatever credibility official government statistics still retain). The stock market continues to languish, plunging sickeningly after every short-lived attempt to mount a sustainable rally. The U.S. dollar continues to make all-time or multi-year lows against the Euro, the yen, the pound, the Canadian, Australian, and New Zealand dollars, the Brazilian real, and a host of other currencies. The greenback still looks awfully good compared to the Zimbabwean dollar—which has inflation rates in the thousands of percent—but that is faint praise indeed.

When I outlined the crisis in December, I referred to what are clinically called “injections of liquidity” by the Federal Reserve that were of the breathtaking scope of $10 or $20 billion dollars in a single day. Ah, those were the good old days! On March 11, the Fed announced that it was injecting more funds—but now with another zero added to the figure, in this case $200 billion. A couple of reports listed the amount as $280 billion, and while I can’t say which figure is closer to the truth, when it is starting to seem like $80 billion if a mere rounding error, it suggests that we are in dire monetary straits indeed.

The $200-plus billion was dispensed to financial institutions in the form of 28-day loans in exchange for collateral consisting of piles of the infamous mortgage-backed securities and their derivatives that—like the “old maid” in the childhood card game—everyone is trying to ditch. Essentially, such collateral has little, if any, actual market value. The Fed issued these loans to give these institutions time to strengthen their balance sheets. Theoretically, they will buy back that collateral in four weeks. Don’t count on it. If the Fed was unwilling that these effectively insolvent institutions fail in March, do you really think that they will dump the financial garbage back onto those weak balance sheets and bankrupt those companies in April?

We can expect more hundred-billion-dollar bailouts. After all, there are who-knows-how-may trillions of dollars of iffy mortgage-backed securities and derivatives out there. By establishing itself as the buyer of last resort of financial detritus, the Fed apparently stands ready to absorb as much of this junk as key financial institutions need to unload in order to survive.

That raises another question: Which financial institutions are key? Given the complexity of intertwining investments and contracts between various firms, nobody can say where the line of demarcation is between firms that the Fed would allow to go bankrupt and those that it considers “too big to fail.” Clearly, Bear Stearns was one of the latter. It was one of the primary dealers and market-makers for Uncle Sam’s existing trillions of dollars of debt. That is why a few days ago the Fed provided funds to JPMorgan to absorb Bear Stearns at the token price of $2 per share—more than $150 per share less than what the venerable but suddenly insolvent firm was trading for last November.

The Fed has set a dangerous precedent with its recent actions. From its standpoint, its extraordinary actions are the lesser of two evils—the grim alternative being to allow the credit markets to grind to a halt and paralyze our entire economy. Politically, giving hundreds of billions of dollars to Wall Street firms that pay 5-, 6-, and 7-figure end-of-year bonuses to its employees, while Joe Sixpack fears for his job and struggles to make ends meet, opens the door wide for clamorous demagoguery, especially in an election year. Economically, the decline in the dollar may accelerate and become a panic, exacerbating the current situation in which the value of Middle America’s primary assets—house, savings, etc.—continues to erode while the prices of the goods we need to buy continue to rise.

Price charts for the commodity index and the dollar have entered a stage where the former is rising and the latter falling parabolically. Such phenomena usually are short-lived and portend a wrenching reversal. Will there soon be a reversal—a strengthening of the dollar and a slowing of price increases—or will continued rapid money creation lead to a near-vertical, hyperinflationary ascent of commodity prices accompanied by a freefall in the dollar? The answer to that question will be determined by the actions taken by Federal Reserve Chairman Ben Bernanke and his colleagues in the coming weeks and months. Keep your seatbelts fastened.