I’ve heard a lot of critics recently from various blogs and comments that the now widely discussed $100 billion “superconduit” that will purchase various junk paper from participating banks SIVs and keep them on its balance, issuing some papers by its own. People just say that this effort will fail.

I think there is a lot of misunderstanding here. By some reason people think that the goal of those efforts is to save the economy and prevent the recession. Where did they get that?

If you look at the charts you’ll see that most banks were doing just fine all way through the recession from 2000 to 2003. The banks don’t mind the recession, it’s not a negative event for them. What banks are afraid is the financial meltdown, credit freeze and other Gomorrah. This fund is set up to help with that and it will. But the price will be dire.

The effects that Lee Adler sees (with my own additions):

  • A lot of liquidity will be removed from the market and will freeze in the fund, i.e. money velocity will decline and free cash available for lending will decline
  • The boost that markets got from the cash inflow out of the ABCP market is over. The stock market is tired
  • In the short term the T-bonds will decline and yield (the price of money) will go up (But the long-term trend for bonds is strongly up)
  • The scenario could be similar to this Summer, when the T-bonds fell in June, then junk bond market crashed in July (because treasuries became so much more attractive) and finally the stock market crashed in August because stocks always follow the junk bonds and Treasuries rallied because of the flight to safety. This 1-2-3-4 game will repeat itself again

Update: a wonderful comment came from Speaker:

The more I look at M-LEC the more it looks to me like we are looking at a Japan scenario here. Japan’s economy has been hamstrung by several things, but a major part of the problem was that the banks had boatloads of bad assets, but rather than take the loss, the banks set aside capital to fund the assets for as long as necessary, thereby removing that capital from the functional economy and basically wasting it. The conventional wisdom has always been that, unlike Japan, the U.S. financial system had the discipline to mark down positions and take the loss. M-LEC suggests that might not be the case. The fear of selling assets at “fire sale” prices echoes of Japan’s thinking, and rather than hitting the bid, banks seems to the lesser evil of tying up capital indefinitely. I still think we are looking at an eventual taxpayer bailout, but at a minimum, we may find ourselves repeating Japan’s tragic stagnation.

Well said…