Fed: blood transfusion

Five central banks -- the US Federal Reserve, European Central Bank (ECB), Bank of England, Bank of Canada and Swiss National Bank (SNB) -- on March 12 took cooperative action for the second time in three months. The Fed has taken the most dramatic steps, with plans to offer primary dealers up to $200 billion of highly liquid US Treasuries, while accepting a broader range of collateral for the loans, including AAA-rated mortgage-backed securities.

The aim is to inject much-needed liquidity into credit markets -- with the most apt metaphor being a blood transfusion to a bleeding victim. The problem is that while these transfusions are 'keeping the body alive', enabling the financial system to keep limping ahead, nothing has been done about the underlying injuries. Even Fed action on the monetary front -- it is expected to cut interest rates further on March 18 -- is having limited effect. The Fed's measures are "not a panacea, more like an aspirin for the dollar", according to analysts for Merrill Lynch's global currency strategy.

Recently these US mortgage securities have been difficult to trade, given uncertainties about the value of the underlying mortgages. The Fed would thus like to stave off a downward spiral of disorderly deleveraging (reducing the amount of borrowed capital, thereby seeking to lower risk). This latest trend is raising market fears: as their margin calls are increased, financial institutions are unable to make debt repayments; they are thus being forced to sell off mortgage-linked securities. In turn, this drives up mortgage interest rates, hits the already suffering housing market, and tightens credit conditions even further.

While the Fed's action may be stabilising in the short-term, the financial system is likely to continue significant deleveraging, even as asset prices -- particularly for mortgages -- are repriced downward. The latest intervention demonstrates that central banks are committed to stabilising the financial system and preventing recurrence of acute liquidity pressures. But there is little they can do to address the underlying problems of solvency arising from fears about mortgage-based assets.

Meanwhile, the victim's injuries continue to compound. 'Blood transfusions' and aspirin may simply not be enough.