The $700 Billion Gorilla – When the Fed sets the price, liquidity and confidence will be restored.

Prices are a funny thing. When there are no buyers, there can be no price. But the minute there is a price that can be identified, a price can be set. It’s all psychological. When you have a price that some buyer is willing to pay, and you have a transaction in which that buyer actually did pay that price, then you have established a reference price.

All the Fed has to do is buy a few tranches of bad loans and presto! the prices they pay become the reference price. At that point, speculation becomes moot and due to draconian mark to market rules, all identical assets immediately are compelled to be revalued at the reference price. That is, all assets IN ALL PORTFOLIOS world wide. Bang! Asset values are reset and liquidity returns.

And all the Fed has to do is buy a few tranches of a carefully calibrated selection of bad loans (e.g. 30/60/90 days past due, 3/6/12 months in foreclosure, etc.) and all like assets in the market are priced accordingly. The prices the Fed paid become in effect a pricing guide to bad loans that will be referred to by all buyers and all asset appraisers.

It might cost the Fed $1 or $2 billion at most to achieve this. If the market balks, then the Fed goes back to the well and buys another $1 or $2 billion. With $700 billion at its disposal, even the shorts will capitulate even if the Fed never spends another dime more than a few billion. The mere fact that the Fed, the $700 billion gorilla, can if it wants to will be sufficient.