Today's announcement that the Federal Reserve will act in concert with several other central banks in unprecedented ways to address troubles in the credit markets provided the spark for a massive melt up in shares. Could today's action be the beginning of something more substantial than the proverbial one day wonder rally? Perhaps, but don't bet on it just yet. Without getting into too many specifics, the Fed is, among other moves, modifying its lending practices such that it will accept AAA rated mortgage securities sold by Fannie Mae and Freddie Mac in exchange for Treasuries for periods lasting up to 28 days, far in excess of the usual overnight lending period.
The Fed is, shall we say, expanding its role as lender of last resort in a fashion that has had, as one might expect, spectacular and salutary short term effect, but that runs the risk of causing unprecedented long term harm. After all, by their decision, the Fed is effectively allowing the rampant toxicity that has infected the entire financial system to directly pollute its own house. Why did they do this? In a word, desperation. The banking system is effectively insolvent and cascading bank failures were probably days if not hours away from occurring. The Fed's move is designed to avert a banking meltdown by giving the tapped out banks and broker dealers that deal directly with The Fed another supply of boodle with which to try and entice folks to borrow. Now that the Fed has put its you know what on the line by demonstrating a willingness to accept clearly dodgy collateral, the price of failure for our entire financial system has grown exponentially. Because, should the Fed's gambit fail and banks are unable to generate sufficient new borrowing, The Fed, the lender of last resort, will be dragged into the same vortex with all the banks and broker dealers that are now desperately trying to avoid the massive black hole they themselves created.