SuperBanks the Solution?

Now we are going to see what a big mess central banks can make of things.

"Central banks seek to unblock markets," says a Financial Times report.

On Thursday and Friday of last week, the Bank of Japan, the European Central Bank, the Bank of Canada and the Fed all began to rise to the challenge. We saw one report that said the ECB had "injected" $215 billion into the system. Others said the Fed had put either $38 billion or $58 billion at work. And a Bloomberg item this morning says that Japan ponied-up $5 billion, which is already having a "calming effect" on Asian markets. Whatever the final numbers turn out to be, it is a lot of new liquidity in a short period of time - more than at any time since the days immediately following 9/11 in 2001. Lending by the New York Fed was so vigorous that the fed funds rate fell to just 1% - the lowest rate since 2004.

Alert Daily Reckoning readers may already be suspicious.

"Now wait a minute," they may be saying to themselves. "Wasn't this whole problem caused by too much liquidity in the first place? Isn't more liquidity going to make the situation worse?"

Bingo!

Oh, dear reader, what a joy it is to watch central bankers at work! What a spectacle! They are charged with keeping this great modern, capitalist economy going. In practice, that means keeping the bubble in speculative finance from deflating too fast. Of course, the bubble is largely of their own making - a direct consequence of the liquidity they injected after 9/11…and the subsequent EZ credit conditions throughout the world economy. And now, Ben Bernanke and the whole company of central bankers from Tokyo to London to New York is hard at work making sure that the bubble gets enough hot air.

Over the last few weeks, serious leaks have developed. First, there was the hole punctured by subprime lending. Bernanke and U.S. Treasury Secretary Hank Paulson immediately announced that this problem was "contained." But then, the gap just kept getting bigger. Builders tumbled. Mortgage companies went broke. Not only were the subprime homeowners going into default…but so were the big packages of subprime loans. And a few hedge funds that owned the stuff were closing their doors.

The hole itself was in the U.S. mortgage market, but major rips seemed to be appearing all over the place. France's largest bank, BNP Paribas, let it be known that it had a few subprime CDOs among the $2.2 billion in assets in three of its funds. It refused to give investors back their money, on the grounds that it could not properly price its assets, and therefore could not give its clients their share of their losses.

This revelation was expected. Nevertheless, it was important.

Many of the most sophisticated investments - such as the Bear Stearns (NYSE:BSC) "enhanced leveraged credit" fund - are now created by teams of mathematicians who presume to develop safer and higher yielding instruments by crunching the numbers in a better way. The resulting portfolios are not marked to market - because there is no ready market for these complicated confections. Instead, they are "marked to model"; that is, they are given values based on the mathematicians' own formulae.

"Value at Risk," or VAR, is the key phrase. But like so much else in modern finance, VAR is one part fancy modern arithmetic and two parts old-fashioned tomfoolery. Risk is not something that can be reduced to numbers, for the simple reason that you can't know what risks the future will throw at you. The mathematicians simply swept aside this fundamental insight and replaced risk with numbers they could work with. They just looked back to see the numbers of the past and assumed that they would be more or less the same numbers in the future…and that markets would keep the numbers coming more or less when they were needed. They knew things didn't always happen as neatly as planned, but they simply dismissed the unknown and unexpected as "anomalous."

What happens when markets seize up is that the numbers stop. You can't get a bid. What's more, the numbers that made sense in the '80s and '90s will not fully reveal the risks in the market in 2007; even 10 years ago was before the rise of the $500 trillion derivative market, the huge, global carry trade and the invention of the neg-am, no-doc ARM. In other words, the innovations of the financial market themselves make their history-based risk assessments obsolete.

Since July 13th, investors have been reluctant to buy CDO tranches, or to finance LBOs, or to take Wall Street's slick products at face value. Most recently, they've been worried about the real value of their stocks, too. This reticence has practically frozen the pipeline that pumps liquidity into the marketplace.

Of course, that is the way real capitalism works. It goes from crisis to crisis…from creative boom to creative destruction. From fully functioning, liquid markets…to markets as frozen solid as the polar ice cap in the days before global warming. From boom to bust…from profit to loss…from wealth to poverty…

But now, in step the central banks. The boom is fine, they say…but we'll put a stop to those nasty busts. How? By providing more credit! The Fed intervened on Friday, buying up the securities that free market players didn't want - including subprime backed mortgages.

We can't wait to see what happens. Will this new liquidity convince lenders and speculators to stay in the game…and thus make the inevitable correction both later and bigger than ever? Or is the bubble already leaking air from so many places that the holes cannot be plugged? We'll see…dear reader…we will see.