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Lehman, Liquidity, and You

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Love. Music. Conservation of energy. Each of these has been claimed to cause the world to go 'round. However, over the last year, we have learned that it is, in fact, money that makes the world go 'round. More precisely, liquidity, or the free flow of money.

Liquidity generally comes from banks, but with the collapse of the U.S. real estate market turning mortgage backed securities into toxic waste and casting doubts over what banks hold on their balance sheets, it has been hard to come by of late. Liquidity is important because when banks have ready access to short-term funding, they are more likely to extend credit to customers (you, me, small businesses, etc.), therefore greasing the wheels of the world economy. So, if banks go into hiding, so do any hopes for strong economic growth.

Attempting to keep financial markets on their feet and the economy steaming forward, the Fed (as well as other central banks) has aggressively stepped in to create liquidity, although its methods raise nearly as many concerns as the deteriorating home and equity markets.

This slope doesn't look so slippery
It started with the Bear Stearns takeover when the Fed extended a $29 billion loan to JPMorgan Chase (NYSE: JPM  ) while accepting some of the aforementioned dubious mortgage-backed securities as collateral.

They also expanded their role as lender of last resort to include financial institutions over which they had no regulatory power (investment banks and brokers) and opened up the spigots by loosening the collateral requirements for short-term loans to the same financial institutions through the Primary Dealer Credit Facility (PDCF) and Term Securities Lending Facility (TSLF).

These steps temporarily increased confidence in the market, thawing frozen money markets, and increasing liquidity through interbank short-term lending activity. Much of this short-term funding takes the form of unsecured short-term debt called commercial paper, which is backed solely by the reputation of the company issuing it.

As you might suspect, it takes a certain someone to be able to issue this type of debt. I couldn't borrow money for, say, a house just by telling people I was good for the money a few months down the road. Um, on second thought, that might be a bad example.

When concerns are raised as to whether or not the issuing company will have the cash available (or be around) to make good on this paper (as happened when banks started doubting the quality of each other's assets), the works quickly become gummed.

Down, down, down
With access to short-term funds cut off, financial firms first turned to equity and debt issuances. However, the distrust regarding their balance sheets limited the effectiveness of these options, and eventually firms began liquidating assets to raise cash.

Unfortunately, when everyone is trying to sell something, the value of that something goes down. Due to accounting requirements, assets on the balance sheet similar to those being sold had to be marked down to reflect new, lower market values, further increasing the need for cash. This is the vicious cycle in which we find ourselves these days.

Fed's encore
This cycle proved too much for Lehman (NYSE: LEH  ) (and Merrill Lynch (NYSE: MER  ) , presumably). In this case, however, there was no government assistance as Lehman filed for bankruptcy. Taking this player out of the system, however, means there is an immediate decline in money supply or liquidity, so the Fed has stepped in once again.

This time around, it further loosened collateral standards for the PDCF (now accepting equities) and TSLF (now accepting any investment grade debt) and abandoned regulation 23A of the Federal Reserve Act.

Read that last paragraph again. The Federal Reserve is now accepting equities, securities which provide the lowest level of capital protection, in exchange for high quality government paper. Anyone see a problem here?

Even more disturbing, regulation 23A prevents, sorry, prevented commercial banks from lending FDIC-insured deposits to affiliated investment banks. This means the money in my Bank of America (NYSE: BAC  ) savings account can now be used to shore up liquidity for some dodgy real estate portfolio that helped pull Merrill under.

Keep in mind, this is occurring at a time when people are calling into question the FDIC's ability to handle insuring deposits if another large bank follows IndyMac down the tubes. Of course, the FDIC can always turn to Congress if their bucket runs dry. But at least taxpayers aren't on the line for another failed investment bank.

Cowboy up
After the credit binge the U.S. and the rest of the world has been on in recent years, there is a desperate need for contraction and consolidation in the financial industry. There is also a desperate need for realism. It is going to be painful, but there is no preventing it. By ignoring the sources of the current pain and focusing on propping up financial markets, the Fed is at best postponing the inevitable, and potentially making it worse.

I know this might be a shock to people in Manhattan and Washington, DC, but a tightening of credit and a slowdown in consumption won't stop the sun from rising.

Nate Weisshaar is often told to cowboy up, but has yet to do so. He does not own any of the stocks mentioned above. JPMorgan Chase and Bank of America are Motley Fool Income Investor recommendations. Try any of our Foolish newsletter services free for 30 days. The Motley Fool has a disclosure policy under its ten gallon hat.

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