The Fed's New Plan Isn't Going to Work

From the WSJ:

In the biggest coordinated show of international financial force since Sept. 11, 2001, the Federal Reserve yesterday joined four other central banks in a plan aimed at coaxing banks to lend more readily at a time when fear has seized up world credit markets.

Just a day after it cut its key rate for the third time this year, the Fed introduced a new tactic, saying it will extend up to $40 billion in special loans in the next eight days to banks. To stoke banks' appetite to borrow and lend, the loans will carry less interest than Fed loans to banks usually do, and still can be backed by a wide range of collateral -- including the high-risk home mortgages at the heart of the current financial crisis.

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The central bank has cut interest rates three times since August by a total of a full percentage point, with the most recent quarter-point cut coming just on Tuesday. But bankers and investors nevertheless have become increasingly jittery, and more reluctant to lend to businesses, consumers and even to each other. Meanwhile, signs continue to spread that the American housing-market meltdown, the related turmoil in money markets and high energy prices are pressing on the U.S. economy. The Fed fears that reluctance to lend could push an already stalled economy into recession.

The Fed has faced two intertwined challenges since the financial crisis hit in August. One has been to cut rates enough to cushion the economy from a collapsing housing bubble, without igniting inflation. The other has been to overcome the credit crunch that stems from the housing woes -- and has muffled the impact of the rate cuts.

So far, the medicine isn't working. The rates banks offer to consumers and each other have stayed stubbornly high. The Fed tried to encourage financial institutions to borrow from its "discount window" but there were few takers. Separately, the Bush administration has prodded big banks to create a new entity to buy some mortgage-linked securities that aren't selling, and has pressed for mortgage-servicers to freeze interest payments on perhaps hundreds of thousands of homeowners whose mortgage payments are set to rise.

First, let's give Bernanke a hand because this is a really good idea in the current environment. In addition, Bernanke has lined-up support from other Central Banks, indicating Ben has some seriously good diplomatic skills. Bottom line -- it's good to see the monetary authorities working together to try and solve the problems in the credit market.

But it's not going to work. Why? Because liquidity isn't the issue; it's confidence. When a lender doesn't think a borrower is going to be around in 90 days -- or that the borrower is going to announce a major write-down to capital within the next 90 days -- the lender isn't going to lend. It's that simple.

The other problem is there has already been $76 billion in writedowns (see the post below). And we're just getting started:

Some of the nation's largest banks on Wednesday warned of higher losses in the fourth quarter as the turmoil in the credit and mortgage markets continues to weigh on the financials sector.

Bank of America Chief Executive Ken Lewis said the firm would have to write down a larger amount of its investment in some debt securities than previously planned.

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Also Wednesday, Wachovia Corp., said it expects to report fourth-quarter earnings is the range of 60 cents to 75 cents a share, and adjusted earnings between $1 and $1.15 a share. Analysts polled by Thomson Financial are looking for profit of $1.39 a share, on average.

In a separate regulatory filing Wednesday, PNC Financial Services Group Inc. The PNC Financial Services Group, Inc said it expects to report fourth-quarter earnings in the range of 60 cents to 75 cents a share, and adjusted earnings between $1 and $1.15 a share. Analysts polled by Thomson Financial are looking for profit of $1.39 a share, on average.

So long as we have announcements like this happening pretty regularly, no one is going to lend to anyone else. Everyone is going to horde cash because no one knows if they are going to be the next financial institutions to announce a write down. My guess is the Fed and the other central banks know this but they have to try and do something.