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The drama continues to play out.

Tuesday afternoon Standard & Poors downgraded 37 global banking giants--hardly a surprise. But when someone points out that the emperor is wearing no clothes, our markets reflexively decline, as they did in Tuesday night’s futures session. Just hours later the U.S. Federal Reserve, the European Central Bank and the central banks of England, Canada, Japan and Switzerland jointly agreed to cut the cost of borrowing U.S. dollars from 1% to just half that. Whether part of a coordinated move or not, the People’s Bank of China simultaneously announced a 50 basis point cut in that country’s Required Reserve Ratio for banks. The appearance of central bank solidarity quickly turned overnight futures from negative to strongly positive. That strength continued throughout Wednesday’s session with the Dow closing up a spectacular 490 points.

The financial press speculated that what prodded the central banks into their stimulative move was the prospect of an imminent collapse of a major bank, most likely French. Interviewed on TV Thursday, former Fed Governor Larry Lindsey admitted the likelihood of a major bank failure this month, but suggested the most probable stimulus to the central bank action to be S&P’s bank downgrades.

At least for one day the stock market celebrated this action as a big deal. One TV talking head characterized it as the banking authorities firing both barrels. On the other hand, it is not an immediate infusion of new money that can be put toward asset purchases. It is rather the expansion of a safety net should banks otherwise be unable to acquire U.S. dollars. One analyst aptly analogized it as putting foam on the runway to limit the damage of a crash.

At the very least, the move is encouraging because it provides clear evidence that cooperation is possible among the world’s largest central banks. At the same time, however, it underlines how severe the current crisis has become. The central banks acted because funding between banks has been freezing up, as it did in 2008, necessitating the greatest bailout in history. The S&P downgrades simply increased the distrust that banks have of their peers’ abilities to repay loans.

Whether or not this central bank action will provide meaningful assistance in calming the European storm is open to question. During the 2007-2009 banking crisis, similar swap line actions were taken four times, typically leading to dramatic stock market rallies. They ultimately failed, however, to promote the desired interbank confidence, which was only reestablished when the Fed provided broad guarantees. Such pledges would be politically improbable a second time around. Notwithstanding the stock market rallies precipitated by these liquidity-providing policy actions, all such gains were ultimately forfeited as the markets continued their plunge of more than 50% to their 2009 bottom.

Even if successful, these rescue actions are designed solely to solve emergency liquidity problems, not underlying solvency problems. And solvency is at the heart of the banking crisis. Bank of England Governor Mervyn King stated this week that the downward spiral facing banks looks like a systemic crisis. And the always insightful Martin Wolf, writing in Wednesday’s Financial Times, warns “…that the eurozone has a choice between bad and calamitous alternatives. The bad alternative is radical policies to promote adjustment, while warding off a wave of sovereign debt restructurings (defaults), financial crises and a true depression. The calamitous alternative is that depression, along with a breakup of the (euro) project.”

As we have stated repeatedly, the ultimate resolution of this crisis is unknowable. A systemic collapse is possible with terribly severe potential consequences to worldwide asset prices. More hopefully, politicians and central bankers will craft a series of plans that will sufficiently boost investor confidence to keep asset prices afloat while the underlying debt problems are resolved, or where that is impossible, restructured. The latter alternative could lead to intermittent powerful rallies. Because the former alternative remains very possible, investors should weigh carefully how much exposure to risk they wish to assume. As recent market volatility demonstrates clearly, good or bad announcements can lead to precipitous moves in both stock and bond markets. In a truly dramatic resolution to the crisis, either positively or negatively, market prices could gap in either direction allowing no opportunity to get trade executions over a very broad price span.

Source: Central Banks Provide Liquidity