Does the Fed Trust the Banks?

Apparently not. They just lent out $70 billion in cash in exchange for agency and mortgage-backed securities. While the $70 billion is not surprising, given that the banks are raising $70 billion for their "Bid on Their Own Crap" fund, the price was stunning: weighted averages ranging from 4.63% to 5.46%. A quick check on Bloomberg showed 3-month LIBOR at 2.82%. Bullshit! All lies! Why would banks pay the Fed up to 6.26% if they could borrow from other banks at 2.82%?

This is a lot worse than it looks. It means that the banks HAVE NO MONEY.

They are paying 6% for cash from the Fed. They can't lend to each other, and they probably wouldn't if they could. It costs too much to hedge the risk, if it's possible.

The whole banking system has just become insolvent. Now there are two ways out:
Option 1:
Take over all the bad banks. This is every bank in the country if need be. Wipe out all common and preferred stockholders, all unsecured debtholders, and 50% of all senior debtholders. Recapitalize the banking system with some of the 50% of senior debt taken from the debtholders. Fed guarantees all deposits, even uninsured by FDIC.
Option 2:
USA becomes Japan, 1990-present. Only worse.