The stock and commodity markets have been rallying based on expectations that the Federal Reserve would implement QE2, aka printing money. I have written about the risks to QE2 here and here and I don't want to beat a dead horse.
Despite the general market strength, stocks fell off yesterday based on fears that the mortgage foreclosure mess would seriously impact the financials.
Is this 2008 all over again?
Others have covered the mortgage foreclosure mess much better than I have so I won't repeat the analysis (see Felix Salmon's comments here and Barry Ritholz at The Big Picture here and here). The risk here is that, if all this mortgage paper is shown to be defective, then someone, somewhere, is going to take a big haircut. Most likely, the haircut is going to show up somewhere in the financial system.
I don't want to be overly alarmist because we really don't have a good handle on the magnitude of the problem. I do have a foggy memory that back in 2008, it was the combination of bad paper and excessive leverage caused a financial panic.
The Fed can supply liquidity but not solvency
Panics are the financial equivalent of fires and central bankers act as fire fighters. During these episodes, the central banker can inject liquidity into the financial system. However, if a bank is sunk by bad loans (or bad mortgage paper that it's holding), then its assets are less than its liabilities, or deposits, and it is deemed to be insolvent. Insolvent banks can't be saved by additional liquidity, they need equity injections.
Just remember this: QE2 can only supply more liquidity to the system, not solvency. Should we experience another solvency crisis in the financial system, then no amount of Fed Treasury purchase can save the system. Something else would have to be done, e.g. another TARP.
The market is already starting to price in the solvency risk in the system. A look at the relative performance chart of the Financials against the market shows that, despite the stock market rally, Financials remain in a relative downtrend and continue to underperform the market. In fact, the sector is now testing a relative support zone, with little downside protection should relative support fail.
The behavior of the Financials highlight the risk to the system. This sector bears watching as a barometer of the robustness of continued strength of the market rally.