In a comment last week, I said,
Treasury Securities are the only assets that can …
… be held be the people that issue the actual fiat money. So, while the US dollar could lose standing abroad and with it would go the top ranking of US Treasuries overseas, it is institutionally entrenched as the AAA ranked US dollar denominated financial asset.
And while the gist of the argument is sound … Treasury Securities are the last financial asset standing if you need financial assets denominated in US dollars, and that is intimately tied up with the way that the Fed works …
… the statement itself is deeply flawed.
In ordinary times, it would be a footnote. The Fed can also hold as assets loan contracts with commercial banks, and other such loan contracts as the legislature may from time to time permit.
Well, how did they keep the current crisis from blowing up? After all, it was late last year that the housing market bubble burst … how did they string it out until September of this year?
How they strung it out was by lending to get financial institutions out of their short term liquidity bind. And as institutions ran out of Treasury Security and “high quality” mortgages to borrow against, the Fed relaxed its standards to allow borrowing against lower quality assets.
Except, the way that the Fed does short term loans with a financial asset as collateral is the same way that the private finance sector does … it enters into a contract to “buy” the financial asset at a set price, and the borrower agrees to “buy it back” at the end of the loan period for a set price. The up-front purchase price is the loan amount, and the difference between the two prices is the interest payment for the loan.
Now, if you are make a temporary bridging loan to a business backed by collateral, and you have to loan more than the collateral is really worth, that ought to raise a red flag that the business is in something more than a liquidity squeeze.
As explained by an anonymous banker friend of Jerome a Paris, that is the current crisis and the current proposal by the Bush administration, in a nutshell.