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Author: FastMike Big red star, 1000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 455448  
Subject: La Conquête du Monde Date: 3/24/2008 8:58 AM
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”...To promote the restoration of orderly conditions in financial markets, the Federal Reserve Board approved temporary changes to its primary credit discount window facility...”


Risk, is the name of a one time very popular board game. It is a game of strategy, but only to a point, at which time, winning, or losing, in one’s turn depends on the roll of the dice.

I personally liked the version which used the small wooded pieces to represent armies. I was also surprised to learn that the original name was ’La Conquête du Monde’ , which translates to ’The Conquest of the World’. Parker Brothers, who named the American version as Risk truly understood what would make the name attractive on this side of the Atlantic.

Risk implies chance. Risk means relying on an arbitrary event, for example, the roll of the dice, in order to achieve a desired outcome. However, not all risks are the same. Risk is, in fact a relative measure and varies in degree.

For example, by determining the least possible risk in a class, say, of assets, a relative measure can be established, for all the assets of the class.

Option Contracts have a higher risk than Stocks which, in turn have a higher risk than Bonds. Asset classes may be further divided into subclasses and again, a relative measure can be associated with the assets in the subclass, like the subclass of debt instruments. Commercial paper, for instance, carries more risk than US Treasuries.

In the debt instrument asset class, the yield on a Treasury, is lower than the other forms of debt instruments in that asset class. And of course the reason for this is that the risk of a Treasury defaulting is lower than the other paper in that class.

So, the risk of a Treasury is a benchmark that the risk of other debt default is based on; it’s a unit measure.

But up to here, I know that I’ve been preaching to the choir, so to say. So let me go on.

What makes US Treasury Debt so secure? We all know that it isn’t the gold reserve. Those days are long gone, and we’d be just plain foolish to return to them.

And it isn’t that the Federal Reserve can print up all the notes that it needs, although it seems that way. Treasury debt instruments are made after government spending has been legislated by congress, and the Treasury is authorized to borrow which in turns requires the Fed to create the cash for the debt.

But any nation can legislate a currency. That’s currency by decree.

What makes our bonds so credit worthy, is the ability of the public to pay taxes. Taxes are what pays the interest and taxes are what guarantees the principle. It’s the fact that our aggregate private wealth is such, that we can cover all of our debt.

Our currency is based on the economy’s ability to produce goods, services and productive reinvestment not just to ourselves, but to the world, and protect our interests here and abroad.

In a sense, we are the leading player in the game of Risk.

One shortfall of a goods and services economy, is that it encourages the Federal Reserve Bank to lower the target lending rate between banks if the economy slows. The claim is that it is better to risk inflation in order to stimulate the economy in its' free market cycle. If growth can be restored, the economy can withstand better an increase in lending rates and un-inflate the currency, at a future time.

But the financial crises that the economy is facing now is primarily due to the mis-assement of risk. Usually the economy falters and the banking system revives it. The present situation has the banking system faltering with the expectation that the economy will revive it.

Clearly, this time is different.

Aside from rate cuts and stimulus checks, the recent government remedies have removed the basic motivation for financial innovation. They have removed risk from capital markets.

When the Fed cut August 17, 2007 it was options expiration day. The equity market downside risk was removed at the wave of a hand. Also announced were the 30 day loans and acceptance of a “broad range” of collateral at the discount window.

Subsequent actions not only tried to stimulate the economy in the usual way, but continued to remove the risk of failure from the bond markets to the Treasury and Federal Reserve Bank.

The March 16, Sunday night discount window rate cut (seemed to me at least), as more directed at stock exchanges than the credit problem as the Fed only had less than 36 hours before it would complete its' complete strategy of cuts after that next meeting. The risk that stock market prices would correct was removed, by decree.

There was an article on the Bloomberg website last evening, speculating that the Fed might be considering the outright purchase of mortgage backed securities. This is somewhat surprising, considering the EU and Bank of England denied that they would undertake those actions, just this past week.

And this morning there are reports that JP Morgan is renegotiating the Bear Stearns take over. JP Morgan undertook the risk, because the government said that they would remove the risk to Morgan. So what has changed? Morgan did its’ part.

Why should the transaction be re-negotiated? Are other investors demanding that the government unwind their risk also? Can macro economic policy be lobbied?

Risk and reward spurs financial innovation. By removing risk, government policy has at the same removed the incentive of reward. By accepting suspect collateral for loans the Fed is doing exactly the same thing as what the mortgage originators did to begin with! And the outright purchase of suspect debt instruments will have to be funded either with more currency, with new debt or the reserves of the Federal Reserve Bank

Should this occur, wouldn’t those countries, who we’ve preached the virtues of a free market economy for decades, realize that there is now an increased risk to holding US Treasuries, and trade those assets, for assets with less risk? Will we witness smaller but strong players taking the risk and rolling the dice to expand its' financial territory, at our expense, as in the board game?

Markets need risk to functions. But who would dare to innovate, who would risk assembling assets pools or investing cash, or leveraging assets, or borrowing assets to ‘hedge' market movements when there is a large risk to the innovator, that government central bank actions will step in and upset natural and free market continuity at any given moment?

By removing the risk of failure, and by removing downside market risk, while at the same time creating inflation, could make any market rally unsustainable, and subject to reversal.

Further, by assuming the risk, the Fed might actually encourage financial institutions to quit that game and find another. Removing the risk of failure might actually encourage more failure.

It is good that we have a Federal Reserve system and it has an important function. But in a free market, cycles ebb and flow, and the growth is not constant. As in the past, excesses reach a point where they must reverse, when they must consolidate, when the weaker players must leave the game and the stronger fewer players acquire the loser's position. This is the system that we abide by and this is the system that, when allowed to operate naturally, has made us the leading player.

It is in our nature to accept risk and the consequences of risk, one way or the other.

Much like one of the mistakes in game of Risk, the Federal Reserve is spreading its’ forces too far, too fast over too broad an area, without enough force to defend that territory.

As that game goes, there are many other smaller, but stronger players who would be willing to risk their smaller, consolidated holdings to take advantage of a weakness and risk a roll of the dice, knowing full well that the risk to reward ratio is in their favor.

On the other hand, our central bank seems to be trying desperately to support an untenable position, with minimal rewards and, indeed, exceptional risks.

Your rolling Fool
FM
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