Last week the financial markets swung wildly back and forth between "We're All Going To Die!" and "Hurray! We're Saved!".
At the center of this drama was the buyout of the insolvent investment bank Bear Stearns by JP Morgan Chase. Most of the attention was focused on the fact that JPM bought Bear Stearns for just $2 a share, thus giving current shareholders the shaft.
While this is a worthy characteristic to focus on, I was more interested in the fact that JPM only agreed to this deal after the Federal Reserve offered to shift $30 Billion of Bear Stearns mortgage-backed securities onto its books.
And then, very quietly, the Fed agreed to accept a wide range of mortgage-backed securities as collateral in exchange for $200 Billion worth of treasuries on Thursday.
March 20 (Bloomberg) -- The Federal Reserve expanded collateral eligible for its auction of Treasuries to include bundled mortgage debt and securities linked to commercial- property loans.
The changes came after "extensive consultation with market participants," the New York Fed said in a statement today. The Fed previously said it would accept residential mortgage-backed securities as collateral and consult on details of the program with the so-called primary dealers, the 20 banks and securities firms that trade directly with the central bank.
It's the first time the Fed will lend Treasuries in exchange for debt that includes mortgage-backed securities. The central bank will increase the program as needed.
As a student of both macroeconomics and history, this all sounded very familiar. So I decided to do a little research.
What I discovered is that this is nothing new.
There is nothing new under the sun
Most people think that everything was fine until the stock market crash on October 24, 1929. Then everything immediately fell apart.
In fact, the economy kept rolling along until the later half of 1930, and it didn't have a full-scale meltdown until the spring of 1931. It was in 1931 when the credit markets completely froze up, and that was the year I investigated.
New York Times, October 11, 1931
New Era In Banks Seen In Hoover Plan
Last week brought forth two developments of extreme important to bankers, each of which, in a different way, is calculated to assist the banks of the country in meeting the hardships brought upon them by the prolonged depression.
The most important step was President Hoover's announcement early Wednesday morning of plans for a $500,000,000 corporation to discount sound banking assets which are not eligible for rediscount at the Federal Reserve Banks.
the formation of the credit organization outlined by President Hoover, on which work was speedily begun by a group of New York bankers, is expected to have a profound effect in relieving bankers of one of their greatest sources of anxiety. The institution is to be called the National Credit Corporation, will provide facilities whereby banks all over the country may realize upon sound assets that are not liquid at present due to abnormal conditions.
So what exactly were those sound assets that were were "not liquid at present"? Why mortgage-backed securities of course. Just like today.
New York Times, October 8, 1931
Real Estate Men On Hoover Plan
Skepticism as to President Hoover's plan to liquidate frozen bank assets was expressed yesterday by Charles G. Edwards, president of the Real Estate Securities Exchange. The exchange deals almost exclusively in real estate bonds, of which it is estimated that $1,500,000,000 at par value are in default throughout the country.
"President Hoover's financial plan," Joseph P. Day said in part, "is a step in the right direction towards making real estate investment more liquid. The system will make it possible for the Federal Reserve Bank to issue acceptance notes against sound real estate securities, thus stabilizing their values. Real estate mortgages are commonly regarded in banking as frozen assets. The Hoover plan seeks to take these substantial investments from the frozen asset class and give them a recognized value."
Hoover's Plan didn't work 77 years ago. Will Bush's Plan, using the exact same strategy, turn out any different? It's possible, but somehow I doubt it. It's not like Bush has a track record of success.
For every action there is a reaction
So other than Bush taking the same failed actions as Hoover, what difference is that to you and me?
Think of it this way: the Federal Reserve, like any central bank, must hold reserves to protect the value of the currency. Historically, those reserves were gold and silver. Since 1971 the reserves have been high-value, low-risk treasury bonds.
But with Bush's "Hoover Plan", those high-value, low-risk treasury bonds are being swapped out for low-value, high-risk, mortgage-backed securities that banks simply can't sell because no one wants them.
This action is not without consequences.
Consider the headlines in the days after Hoover's Plan was announced:
New York Times, October 10, 1931
Poles Sell Savings Of Dollars In Panic
New York Times, October 15, 1931
A further loss of gold, amounting to $48,485,400 was reported yesterday by the Federal Reserve Bank, making the net loss for the two business days of this week $89,060,800, and the total since England went off the gold basis on Sept. 20, $588,224,700.
The reason for the exodus of gold was because of a loss of faith in the value of the dollar by foreigners, and the fact that America was still on the gold standard at the time.
You can see the same pattern repeated under Bush's Hoover Plan when you look at the dollar index today.