Why the tax rebates won't work

My bitter summer scenario could be thwarted by a dose of financial saccharine: It's all about generating new sources of money out of thin air to replace the cash that is being sent overseas, and that is something that both the Federal Reserve and Congress specialize in when given the slightest nod by the political leadership. I mean, what's the point of owning a mint unless you're going to use it from time to time to juice the system?

This is why the Fed has embarked on a stealthy plan to try to make all this unpleasantness go away, and it just happens to have already provided enough money to match the spending power that has been eroded away by fuel prices. According to David Kotok of the hedge fund Cumberland Associates, the Fed this year has provided the world with $106 billion of "high-powered" money at an interest rate of 2.1% through a widely announced but little-understood program called the Term Auction Facility, or TAF.

The TAF was invented last year by the Fed to encourage banks and brokerages traumatized by bad mortgage loans to seek federal help quietly and in unprecedented quantity. It's like a no-questions-asked halfway house for addicts that provides unlimited methadone.

Unlike bellying up to the Fed's old "discount window," at which banks must publicly announce their names and problems before getting overnight loans secured by their highest-rated collateral, the TAF expanded its lending to beleaguered brokerages and allows both banks and brokers to bid for new funds without public notice.

Iffy assets

Not only can banks put up their skeeviest mortgage assets as collateral, but the TAF lets them keep the money for 28 days instead of overnight, and they can roll over the loans at the end of that span.

This creates money from thin air because those assets are mostly not generating cash flow and cannot be sold anywhere else. It's as if you dumped all the junk in your house into a Magic Money Machine and out came bundles of $100 bills you could keep indefinitely. Former Atlanta Fed chief economist Bob Eisenbeis told me that it "allows you to liquefy assets that normally wouldn't be liquid."

Kotok figures that the Fed has delivered $75 billion to U.S. institutions, $25 billion to European banks through an extraordinary "swap" system and $6 billion directly to Swiss banks. That's all on loan at 2% at a time when inflation is north of 2.5%, so it's essentially free.

The TAF has been oversubscribed by bidders, as you might imagine, and the Fed is expected to keep it in operation for months until the credit crisis truly passes, rather than when the optimistic Wall Street executives claim it has passed. Conservative commercial banks want it closed as soon as Sept. 1 because they resent the competition for funds from risk-taking brokerages, while brokers are begging to keep it going.

Fed Vice Chairman Don Kohn calls the TAF a new weapon in a "calibrated" policy to rescue the world financial system from its mistakes, and yet it looks to me as if the program will only end up helping financial institutions lend enough to help consumers and companies deal with rising energy prices.

What we have now is a classic "wind versus tide" matchup in the financial markets: Over the next three months, we will see if the wind blowing money into the United States from the Fed and the tax rebates can overcome the tide of higher fuel prices and lower corporate earnings that are taking money out. It's still a close call at this point.

The advantage is now with the tide, or bears, but it has seldom paid in the past five decades to fight the Fed. Get set for an epic summer battle.

Meet Jon Markman at The Money Show

MSN Money's Jon Markman will be on hand for the 30th anniversary of The Money Show San Francisco, Aug. 7-10 at the San Francisco Marriott. He'll be among more than 50 investing experts you can learn from in more than 150 free workshops designed to help you face an uncertain market. Admission is free for MSN Money readers.

To register, call 1-800-970-4355 and mention priority code #009552, or visit the Money Show Web site.

At the time of publication, Jon Markman did not own or control shares of any company mentioned in this column.

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