[Dogpile]

heard an inteview on Friday that explained this pretty well.

basically the problem is that financial institutions don't trust each other right now. they do not know what securities the other firm is holding and so they question each others ability to act as a counter-party for transactions.

think of it like you borrowing or lending money to another trader. you don't know what derivatives he might hold in his account. is he a credit-worthy or not? will he be solvent tomorrow if he has sold a ton of puts and the market gaps down huge?

now keep in mind that the financial services industry is highly regulated and you need to hold a certain amount of 'reserves' against whatever it is you hold (just like the margin requirement in your brokerage account -- you can only 'extend' yourself so much). financial institutions basically have to value their portfolio of securities and show what it is worth on a nightly basis (as I understand it) and hold enough reserves against that just like you or I do on a nightly basis with our brokerage accounts. but with such volatility, it is unclear what tomorrows volatility is going to do to the value of your current (complex) portfolio that is valued today (especially due to the huge growth of derivatives).

what the fed can do is loan money to a firm that ensures that they can borrow from the fed to carry them for 1 more day. this comes in the form of a 'repurchase agreement' (a 'repo'). The fed basically agrees to buy securities from you for a day and you agree to 'repurchase' them tomorrow. this buys you a little time to weather a near-term storm because you will now have the 'reserves' necessary to not get a margin call. this time, the fed did a 3-day repo because there was the weekend and thus the banks will 'repurchase' the securities on monday by whatever amount they agreed to on friday plus the days worth of interest. Or of course a new repo could be issued by the fed to go another day or more.

what this does is allow financial institutions to trust each other again as even if a firm has an exposed portfolio... that firm can just borrow the amount needed to cover the loss of value in order to maintain its reserve requirement. basically, the confidence it builds is the crucial element. it shows that the fed is not going to let a crisis spiral out of control needlessly. if a firm does really blow up and the lack of confidence was justified in the first place, then everyone is really going to panic and we will probably crash -- no matter what the fed does.

that is how I understand it... comments by others would be helpful.