More Stock Market Mayhem by Mike Whitney

Last Wednesday, the Federal Reserve dropped its benchmark interest rate by 25 basis points to 4.5 per cent citing ongoing weakness in the housing sector. As expected, the stock market rallied and the Dow Jones Industrial Average went up137 points. Unfortunately, Bernanke's "low interest" stardust wasn't enough to buoy the markets through the rest of the week.

On Thursday, the hammer fell. The Dow plunged 362 points in one afternoon on increasing fears of inflation, a slowdown in consumer spending, a steadily weakening dollar and persistent problems in the credit markets. By day's end, the Fed was forced to dump another $41 billion into the banking system to forestall a major breakdown. This is the most money the Fed has pumped into the financial system since 9/11/2001 and it shows how dire the situation really is.

Why do the banks need such a huge infusion of credit if they are as "rock solid" as Bernanke says?
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In the last two months, the pool of qualified mortgage applicants has contracted, as has the market for merger and acquisition deals (private equity). So the banks are probably doing more with the Fed's $41 billion injection than just beefing up their reserves and issuing new loans. The market analysts at Minyanville.com summed it up like this:

"Banks are taking the liquidity the Fed is forcing out there through the discount window and repos. After using it to shore up the declining value of their assets, they have excess to lend out. Finding no traditional borrowers that want to buy a house or build a factory, the new rules the Fed has set forth allows the banks to pass this liquidity onto their broker dealer subsidiaries in much greater quantities. These broker dealers are lending thus to hedge funds and margin buyers who are speculating in stocks. Remember, the Fed is powerless unless it can find people to borrow the credit it wants them to spend. By definition, the last ones willing to take that credit are the most speculative."

This is a likely scenario given the fact that the stock market continues to fly high despite the surge of bad news on everything from the falling dollar to the geopolitical rumblings in the Middle East. Last month, the Fed modified its rules so that the banks could provide resources to their off-balance sheets operations (SIVs and conduits). If the Fed is willing to rubber-stamp that type of monkey-business; then why would they mind if the money was stealthily "back-doored" into the stock market via the hedge funds?

This might explain why the hedge funds account for as much as 40 to 50 per cent of all trading on an average day. It also explains why the stock market is overheating.

The charade cannot go on forever. And it won't. Rate cuts do not address the underlying problem which is bad investments. The debts must be accounted for and written off. Nothing else will do. That doesn't mean that Bernanke will suddenly decide to stop savaging the dollar or flushing hundreds of billions of dollars down the investment bank toilet. He probably will. But, eventually, the blow-ups in the housing market will destabilize the financial system and send the banks and over-leveraged hedge funds sprawling. Bernanke's low interest "giveaway" will amount to nothing.