“The plan does seem sensible. The latest problem in the banking system is the illiquidity of even the best quality mortgages, which are clogging up banks’ balance sheets.”

The quote above from the Financial Times about the Fed’s plan to allow banks to swap “the best quality mortgages” for T-bills I think illustrates that people still don't really understand the problem.

The latest issue to roil markets was solvency concerns first raised here in Minyanville about Bear Stearns (BSC). Add Fannie Mae (FNM) and Freddie Mac (FRE) to the list of financials facing legitimate questions about capitalization and one can see why the Fed felt compelled to act. 

Meanwhile, central banks are still trying to convince markets that the financial system is merely experiencing “liquidity” problems. But if liquidity were the only issue, all the pumping the Fed and other central banks have been doing already should have cleared up this problem.

The problem isn't one of liquidity. It's one of solvency: loans banks made (especially through the derivatives market) are worth less now than when they made the loans. Because they made way (100 ways) too many of them, banks in general have no capital left. You can’t make loans if you don’t have capital. 

So the Fed has to give the banks capital. This latest scheme is extremely troubling, especially for the already-battered dollar. The Fed is taking on “AAA mortgages” from the banks in exchange for Treasury Bills to give banks the capital. Of course we don’t know the price they are taking on these mortgages at and that is the crux of the matter. Everything is price.

So now the Fed has mortgages on its balance sheet instead of T-bills. Why is this so troubling? It is a slippery slope to more currency debasement.

Let’s say the mortgages continue to deteriorate in price (which is highly likely given the nature of our rating system to make them AAA) and then the banks are in no shape to take them back. If the Fed is stuck with declining assets it too will have a capital problem. But if the Fed loses capital it won’t go bankrupt like a regular company: It will just print the money to make up the difference. Literally.

If the Fed loses $50 billion, it can physically print (tell the Treasury to print) the currency to make up this difference. If there currently is $700 billion of physical currency in circulation, printing $50 billion new money would immediately devalue the dollar by 7%.

If the Fed takes on riskier and riskier loans, it becomes more and more negative for the dollar. A collapse in the dollar is a de-facto bankruptcy by the Federal Reserve and the U.S. in general.

It hurts anyone earning a living in dollars and makes them poorer relative to the rest of the world. So far the Fed has chosen to hyperinflate at every turn. We will see if they ultimately have the courage to let the market finally fix the problem.

Risk is high.

Check out Hoofy and Boo's report below for more on the dollar's issues.

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