The mother of all Ponzi's? Some recollections of 2008

Background:  The day of Lehman I was watching, as usual, CNBC at the open.  The reporter on the floor of the NYSE at the open was asking brokers what was going on and one broker said everyone was calling their wives to tell them to withdraw as much cash as they could from the banks.  The reason was banks might not be able to operate as usual and honor transactions drawn on other banks.  In other words, you write a check to pay for dinner on your then Wachovia checking account and give it to the restaurant cashier who would otherwise normally deposit it into their Nationsbank account.  But the cashier, knowing that Wachovia has troubles and knowing that Nationsbank knows it, won't take the check because she knows that Nationsbank won't take it because Nationsbank knows the Federal Reserve can't clear it against Wachovia because Wachovia no longer has reserves at the Fed.  That day the interbank borrowing rate sky rocketed (see the below chart from Wikipedia regarding the "Ted-spread") reflecting the distrust among banking institutions.  That day General Electric, the consummate borrower in ultra short term commercial paper, had about 4 days of cash with which to operate and there wasn't a bank that would touch them (enter Warren Buffet with Fed and US Government guarantees).

As we know, the Fed has gone to extraordinary measures in shoring up and fixing the banks.  And, by most ongoing standards and, supposedly, the 'stress' standards, the banks are fixed.  Lot's of reserves at the Fed, no problem.

But the Fed has nearly $5T of debt and assets now where pre 2007 it had less that $1B.  All the bad paper that was off loaded from the banks and low yield US debt.  A lot of that stuff has 'seasoned,' but a lot of it hasn't.  A lot of it is short term US debt but a lot of it is not.  I caught an interview with a regional Fed president yesterday (March 25) and he wasn't exactly comfortable with the size of the Fed balance sheet or what would happen during the forthcoming unwind.  I recall an article several months ago about how large the paper loss was at the Fed when the US 10-year budged up XX basis points that week (it was on the order of 20 basis points and they lost $100B).  I even more vaguely recall that in 2008 part of the Fed's actions were predicated on the Federal government backstopping Fed losses during the 'extraordinary measures' period.  Geez.  

Questions.  So, we have solvent banks but a potentially insolvent clearing mechanism.  What happens if the Fed burps?  Who will become the clearinghouse between individual banks if its one clearinghouse, the Fed, is not creditworthy?  Do banks revert to the horse and buggy days where each city's bankers meet with one another and hand checks back and forth to clear their accounts ("city clearing").  So now its not 5 or so 'too big to fail....its one too bigger to fail?

And what about the value of that mandatory Fed account on each individual banks balance sheet?  The individual banks become balance sheet insolvent again-all Fed correspondent banks.

And can a government with $17T in debt and an annual deficit of $1T (plus or minus $500B, but who's splitting hairs) credibly backstop a failed banking backstop?

What a Ponzi.

[Do check the 'facts' above as its all recollection.]

Jim