It is all about the banks.....

Over the last few weeks, a question has bugged me. Could the sub prime crisis bring down a major US investment bank? The crisis has already destroyed some 220 small financial institutions. It also forced Bank of America to bail out Countrywide, one of America's largest sub prime lenders. But what about a gorilla? Could it take down one of the big beasts roaming the financial jungle?

There are two badly wounded investment banks out there; Citigroup and Merrill Lynch. Out these two, Merrill looks the most vulnerable. In early January, the bank reported the worst quarter in its history, forcing the bank to write off $16 billion due to sub prime investments.

How much of a financial hit is $16 billion to a bank like Merrill? These days, balance sheets are available with a click of the mouse. Merrill started out in 2007 with assets amounting to $841 billion, and liabilities of $802 billion.

Subtracting assets from liabilities gives the bank's capital, which is the loss-making shock absorber. So long as the bank has a sufficiently large stock of capital, the bank can ride calamitous decisions like investing in sub prime assets. Simple arithmetic tells us that at the end of 2006, Merrill had capital amounting to around $39 billion.

The Merrill website has a couple of further, more interesting numbers for capital. During the first quarter, bank capital increased by around $2 billion, to around $41 billion. By the end of 2007, the bank had owned up to the losses. As a consequence, bank capital fell to $32 billion. In simple terms, sub prime investments burned up around 24 percent of Merrill's capital.

Looked from the perspective of bank capital, these losses are mighty. While subprime has not put the bank in any immediate danger of insolvency, neither is the bank in any shape to absorb any further shocks.

So when Bernanke met with the rest of the FOMC on Monday, he almost certainly had Merrill foremost in his mind. With the stock market crashing on monday, he had a vision of a further financial shock ripping through the banking system, zapping bank capital, much like the sub prime crisis did in 2007. He may be worried about a recession, but he is petrified of a major bank sinking into bankruptcy.

There is only one way he can help; reduce rates. This will allow banks like Merrill to increase their spreads between borrowing and lending money. Over time, bank profitability will improve and gradually bank capital will recover.

However, the rate cut comes at a time when inflationary pressure in the US is at a 17 year high. The CPI is now over 4 percent and will almost certainly rise further. After several years of relentless dollar weakness, import prices are rising.

However, when it comes to choice between Merrill or inflation, the Fed knows what to choose. It will be Merrill every time. This leads us to a profound conclusion. Whatever the Fed may say, monetary policy is there to serve Wall Street.