Bear Stearns finally ran up the white flag today and was forced to seek funds from JP Morgan for 28 days. These loans have been underwritten by the Fed essentially preventing Bear Stearns going under.

This was the moment of truth for the Fed. They blinked.

Now they have underwritten the US banking system they will have no choice but to support any institution that experiences similar problems. On one hand this is a prudent move as the implications of a bank failure are very serious but the sad fact is that in order for the market to recover from this era of cheap and funny money is to allow failure to occur.

So the taxpayer can now expect to pick up the tab for this party. It will be interesting to see if this spreads outwards from the US as the credit markets simply disintegrate.

Expect more official action next week probably involving currencies as well.

Yesterday the New Zealand arm of the Dutch giant, ING, suspended withdrawals from 2 of its funds affecting some 8000 investors. The 2 funds were invested mainly in credit securities and were down over 20%-25% over the last year.

So nothing new there except the suspension of withdrawals from the fund. Now we’ve seen this already in the banking sector when Northern Rock closed its doors to depositors. Last month Scottish Equitable told 129,000 investors that they could not access funds for at least a year. Its familiar and sad story.

What’s the world coming to when you savings or cash is not safe.  Well maybe we’ve got too comfortable with our present financial arrangements. Have you ever met a poor investment banker? Well probably not. The last 15 years has seen a phenomenal rise in the idea of money as an asset class itself. The ability of banks to create money via debt and ply the financial system with leverage has led to a new type of investing. The ability to create money out of nothing is how markets have grown to the size they are now. It’s not a zero sum game as long as the supply of money and leverage keeps increasing. No one embodies this more than Stephen Schwarzman of Blackstone. Just as George Soros and Michael Milken of previous years, he will be known as the man who made the most of the situation at the time.

What we are witnessing now is the de-leverage when all that new money goes poof! and people look around to see where the security or asset is and find it’s more of the same. Round and round it goes until it simply disappears (money is destroyed) or an asset is finally found to be sold, usually at an extremely low price.

So its pays to be sensible here. Check your savings and investments. Make sure you understand what type of access you have to them and under what terms.

With rumours continuing to circle around main street financial institutions in trouble, the Fed along with other central banks piled in another $200bln worth of liquidity in a vain hope to stem the tide. It certainly worked sparking a massive rally in the US market which was looking very weak indeed.

I wrote 6 weeks ago that the Fed would have no option other than to underwrite the whole financial system. This is exactly what they are doing. The worrying aspect of this approach is that it leads the market to depend on continuing liquidity to provide confidence and prevent what would be happening without intervention, namely a full scale rout with several institutions going under.

This creates extreme moral hazard. Even though many financial institutions have clearly acted irresponsibly and in some cases in other ways, they will not be allowed to fail unless a “deal” is worked out where they will be “acquired” quietly for a nominal sum and so the system stays solidly in place and the illusion is maintained.

F.William Engdahl lays out his thoughts on the origins of this mess. It’s focus is the US over the last 100 years and is interesting to read though he makes some strong accusations about the actions of certain people.  The extent to which small cliques have organised and run the financial system is open to questions but there is no doubt that the US prevailed at Bretton Woods on the strength of pure self-interest.

So what now? Well I would say more of the same. But gravity is a powerful force and its hard to imagine these markets not falling further and more de-leveraging taking place in credit and carry trades. I’ll discuss shortly what a new global currency system might look like because the current one is about to explode.

So the Fed yielded to pressure and cut the discount rate. Come borrow more they say….so much for a prudent approach to banking. But really they have no choice. They will just keep flooding the market with dollars for as long as it takes.

The market rallied as expected but it’s hardly a vote of confidence in the system. There will be an expectation of a cut in the funds rate at some point if credit woes continue. The problem is that the last few weeks have been so volatile that for many the opportunity to liquidate positions has not been possible.

Flight to quality has seen the $ rally except for that old favourite $Yen which has taken a pounding.

Who would want to own $? This flight to quality argument alway amuses me given the world is awash with $ and $ assets.

The volatility in the fx markets has been extreme reminding me of the Stg ERM debacle. It just shows that the leverage in the market creates an instability in the system which causes wild swings.  The range mileage in KiwiYen on Friday was the biggest i;ve ever seen in any currency pair…22 big figures in 24 hrs….thats 27.5% in absolute terms of up and down movements.

You would need Kevlar pants to trade that pair. I’ve been trading small amounts but cannot imagine much volume getting through at any reasonable spread.

This is market dislocation. The Fed can cut rates all they want but it wont help people who are under water whether owners of houses on 100% mortgages or funds with boatloads of credit on their books.

Another wild week beckons so expect more central bank ministrations.

The credit inspired boom of the last 15 years is now over. Markets are in severe dislocation and whilst underlying economies are very sound there is a serious problem in global banking liquidity.

On the good side we have record low unemployment and company profits are in good shape. But the driver of that has been consumption driven by an expanding money supply which has driven up asset prices and created a wave of paper wealth.

Interest rates have been hiked up to halt this boom. It’s too late. The record low rates in the US over the last 5 years created easy money that was too good to refuse. As rates were jacked up people realised they hadn’t done their sums properly.

Wave after wave of derivative offers, capital guaranteed notes and other “too good to be true” offers have come pouring forth. There is nothing so easy as making money out of money.

But mathematics will always intervene. Compound interest takes no prisoners in its tsunami like advance across personal and corporate balance sheets.

The central banks now have no option but to step in and sort this mess out. The risk of systemic crash is clearly a possibility now, not just in stock markets but banking systems.

Whether markets can recover from here is a moot point. They always do eventually whether its months or years.

If the consumer goes to sleep expect a recession plain and simple. It wont matter where you are or what you do.

The important point is that our financial systems need a serious revamp. The gross expansion of the global money supply, condoned by the global central banks, needs a full inquiry.

Nothing less will do.

For those not in New Zealand a lolly scramble comes at the end of the party when you throw heaps of sweets amongst the children and watch them go beserk. Of course once they have gorged themselves they fall in a heap as the sugar high follows by a big crash.

What we are seeing in the global markets is nothing short of a major fiasco. Banks wont lend to each other so the central banks have flooded the market with cash.

Come and get it they say. This is now starting to get silly.  They were at it again last night as well. When is it going to end?

Goldman Sachs came in with a $3bln bailout for a fund last night as well talking the deal up as a winner. Well of course there will always be distressed sellers in a credit crunch. We’ve seen it here in New Zealand with finance companies going bust with alarming regularity over the last couple of years.

The problem is that we haven’t even started to see the real pain. The real economy is quite strong globally as the spin offs from the asset price boom feeds through in consumption. But how long is that going to last. In New Zealand we are seeing housing activity level off and prices come off the top. Today we saw weak retail sales.

What I observe here is that many properties remain unsold as people will not take lower prices. This is not reflected in the data. Many properties are withdrawn unsold or just sit around in the hope some mug will pay up for them.

So at the moment we are in the distressed phase of the market sell down. People who have to sell must sell and we are starting to see that. The question is whether it slowly spirals out in the main market. We are clearly at a turning point in the economic cycle. Years of asset price increases, consumption driven higher on the back of that wealth effect, central banks with no control over the money supply, late to raise rates, now hammering rates rises home as prices peak, people locked in at high prices and high rates, wages and labour very tight………it’s a recipe for recession.

This is why the central bankers are still talking tough on inflation. They don’t want to start talking in worrying terms in case they “cause” a slowdown.

So expect the lolly scramble to continue.

But there will be a price to pay afterwards.