Back Door Bailout / Is Fed Buying Bank Stocks?

Could the Federal Reserve be the driving force behind the recent surge in stock market prices?  Since mid-March, the aggregate value of stocks has increased $6 trillion and experts are wondering where the cash is coming from.

TrimTabs, a market research firm that services 25% of the top 50 hedge funds in the world, compiled a report on cash inflow into stocks and could only account for about $250 billion of the $600 billion required to boost stocks to their current value.  The $250 billion included investments by pension funds, individuals, and foreign investors.

Liquidity injection into markets through the purchase of stock is not without precedent.  Central banks in Asia and Japan, in the grips of economic turmoil,  purchased equities to prop up their markets.   The strategy was roundly criticized by Federal Reserve officials here in the US.  Among the most vocal critics was Federal Reserve Chairman, Allan Greenspan.  The criticism waned when the central banks pulled out of equities and realized substantial gains.

Given the dynamics of the current economic crisis and the political mind set in Washington, results might not be the same if a similar strategy is being attempted by the Fed here in the US.  In fact, such a strategy could trigger a market collapse, plunging the economy into another deep recession, and possibly a depression.

The current up-tick in stocks was led by a resurgent banking sector, leading many people to wonder “How are banks making money in this economy?”  Banks make money by borrowing it from the central bank at the discount window and then lending it to businesses that expand and buy equipment, and to home buyers and households that use the money to buy big ticket items–a.k.a. economic growth.  In case you haven’t noticed, that isn’t happening.

At the height of the financial crisis, TARP injected cold hard cash into the banking system to sure up the reserves required to resume “normal” lending practices that in theory would lead the economy back to full employment.  It didn’t work out that way.  I would venture to speculate that the failed policy, and the administration’s inability to force the banks to resume “normal“ lending practices, may have prompted the early defections from the Obama economic team that devised and orchestrated the whole scheme.

The banks, still reeling from sub-prime losses and mounting foreclosures remained skittish about lending to even the most credit worthy businesses and consumers.  Enter Fannie and Freddie with the full faith of the American taxpayer behind them to buy up the bad paper and inject more cash into the system.  Still no lending.

Banks, flush with cash and with losses being passed off to the taxpayer, were in a great position to make money, but decided safety was the best strategy.  The money borrowed from the discount window at zero interest was invested in short term securities with a small yield.  Instant profits, no risk.  How does that create a job?  The only thing created is more debt on the backs of taxpayers.

If the Fed is injecting more money into the system by purchasing equities, the strategy makes no sense because banks are already flush with cash they are unwilling to lend.  This leads me to believe that the motive behind such a strategy is simply to build confidence in the financial sector, thus drawing in the broader market, inflating all equities.  Such an inflation could spur confidence if consumers see secure pensions and rising 401K accounts.  If consumers are confident, they spend money. Unfortunately, if they don’t have a job there is no money to spend, and this economic strategy, one that does not spur lending, will not produce a single job.

In the manipulation of the animal spirits lies the problem.  The American consumer, having been thrashed by the recession is highly skeptical of government intrusion into economic affairs, and a back door bailout orchestrated in secret could very well be the straw that breaks the camel’s back.  The smoke and mirrors game being played, if exposed when we are most vulnerable, could result in capital flight from the markets in fear that quite frankly, perception is not reality.