The Federal Reserve widened the collateral it accepts for loans to securities firms to include stocks in an effort to help Wall Street weather Lehman Brothers Holdings Inc.'s plans for bankruptcy.
The road to this ruin began when the mortgage industry started going wild on sub-prime home loans. These were loans made to people with less than good credit, marginal ability to pay, using the purchased house as security. As long as the real-estate market kept booming upwards, everything was fine.
But gravity can be a bitch and what goes up must come down, and as soon as home prices began to fall, loans started defaulting. The problem cascaded upon itself, accelerated by ARM upwards adjustments on the people still making payments to cover for those who were not. This in turn created more defaults, and the system faw down go boom.
So, here we have the Federal Reserve making loans to brokerages, who clearly may have some problem repaying. And as collateral the Fed is taking stocks. This will work fine as long as the stock market continues to climb, but the market has been in decline for quite some time, and tomorrow will probably see a major drop. We risk seeing a re[eat of the cascade effect when home prices dropped and put homeowners into technical default. If the Federal Reserve loans out $80 billion to the investment banks, and the stock market drops, or he investment banks collapse, guess who will get stuck with the bill?
Even $80 billion may not be enough. The total derivatives exposure for Lehman is ten times that amount. Those obligations do not just vanish in a bankruptcy. There are counter parties to every one of those securities, who may themselves be driven under by a pennies on the dollar liquidation.
The problem with this latest move by the Federal Reserve is that it continues the process of transferring the risk/losses from the investment banks and their stockholders onto the backs of the American taxpayers.