It goes without saying that, in the financial markets, past performance may not be indicative of future results. That’s a fine little homily to remember when you’re an investor picking a mutual fund or buying a stock. But it’s downright frightening for policy-makers when what’s at stake is the survival of the global financial system.

Yet, financial system stability is precisely what is on the line as central bankers and policy-makers try to keep financial markets working amid the ongoing disruption of the credit market that began late last summer. And they are finding that the actions that might have stabilized markets in the past — rate cuts and funding infusions — don’t appear to be working.

“It is now painfully obvious that crisis prevention has failed,” says Merrill Lynch & Co. Inc. economist David Rosenberg, adding that the U.S. Federal Reserve Board has now moved from crisis prevention to crisis management.

The urgency of the situation was crystallized most clearly for many market-watchers on Mar. 14, when it was revealed that large U.S.-based investment bank Bear Stearns & Co. Inc. was on the verge of collapse.

The dire situation at Bear Stearns sent the Fed scrambling to stabilize the situation — not because it is in the business of bailing out almost bankrupt investment dealers, but because the collapse of a significant player could have dire repercussions on the financial markets at a time when investor confidence is already shaky and appetite for risk has evaporated.

In rosier market conditions, the Fed presumably could have let a firm such as Bear Stearns fail. Although the results would not have been pretty, they probably would not have been catastrophic. But in the current market climate, such a failure would be much more damaging.

That’s because central bankers are already fighting an uphill battle to keep markets functioning. Not only have bankers in the U.S. and, to a lesser extent, Canada been pumping liquidity into the system by lowering interest rates, they have also been conjuring up a variety of ways of getting money into the hands of the financial services firms that keep markets moving.

Central bankers have boosted the size of planned auctions, created new lending facilities, agreed to accept a longer list of securities as collateral and expanded the roster of firms to which they are willing to lend — all in an effort to get more money flowing through the system so that firms that need funding can find it and aren’t forced to sell assets, thus driving down values and sparking more panic.

Among all of these moves, perhaps the most dramatic was the Fed’s decision to provide a new lending facility to primary dealers such as investment banks and brokerages, and not just to the deposit-taking institutions to which it usually lends. Merrill Lynch says the Fed hasn’t taken such a step since the Great Depression. Analysts suggest that the Fed probably felt it had to offer this facility in order to assure brokerages that they wouldn’t face the same kind of liquidity crunch that apparently killed Bear Stearns.

Indeed, at the same time the Fed announced this new lending program for dealers, it was revealed that a deal had been reached that would see Bear Stearns’ long-time banker, J.P. Morgan Chase & Co. Inc. , buy Bear Stearns for just US$2 a share, well below its last closing price of US$30 a share. (The bid has since been increased to US$10 a share.) As part of the deal, J.P. Morgan is guaranteeing Bear Stearns’ trading obligations. But the Fed is also committing to fund up to US$30 billion of Bear Stearns’ illiquid assets.

News of the bailout and the lending facility was, in turn, followed by another large rate cut at the Fed’s scheduled weekly meeting. It dropped rates by another 75 basis points, taking the key Fed funds rate to 2.25%.

These measures seemed to bring some comfort to the markets. A report from Morgan Stanley & Co. Inc. calls the latest rate cuts and the lending program “complementary” measures: “Our financing desk believes that the new facility represents an important positive step for the financial markets, since it could serve as the backstop for primary dealer financing of a wide range of assets, and this should lead to reduced counterparty concerns and improved liquidity.”

@page_break@However, other market-watchers aren’t as confident that this latest round of measures will restore the markets to more normal conditions.

“The Fed is pulling out all the stops in its efforts to stabilize the credit markets and reduce risk aversion,” says a research note by Montreal-based BCA Research. “Thus far, the main achievement has been to drive the [U.S.] dollar sharply lower and, in the process, push up oil and gold prices.”

The BCA report says that actions such as the Fed lowering the discount rate and promising to lend to dealers may prevent another Bear Stearns-like collapse. However, the report argues, these moves don’t change the fundamental fact that confidence is shaky: “Although access to the discount window may have forestalled Bear Stearns’ fate, the markets have already demonstrated their tendency to penalize any firm that shows weakness.”

Borrowing at the Fed’s discount window is seen as a sign of weakness, so many commercial banks refuse to use it. Investment banks may prove similarly reluctant.

Auctions through this new facility will be held on a weekly basis, beginning on March 27 (after Investment Executive’s printing deadline). It remains to be seen how popular this measure will be.

What is clear is that earlier efforts to add liquidity through the traditional banks hasn’t done much. A J.P. Morgan report says that is “largely because the core of the liquidity crisis is the market for structured investment vehicles that has grown outside the walls of the regulated banking system. Giving banks more liquidity does not help much if they do not want to lend to SIVs and hedge funds that need the funds.”

But even if the brokerage houses prove willing to make use of the Fed’s largesse, that probably won’t alter the fact that investors remain risk-averse. Nor will it resolve the underlying weakness in the U.S. housing market. “Counterparty solvency is and will remain an overriding concern until the underlying problems are addressed: falling house prices and rising foreclosures,” the BCA note suggests.

Indeed, it will take time for the markets to regain their footing. “Time to allow for more unwinding, time to allow us to gauge the contours of the recession and time to let central banks reduce the return on cash,” says the J.P. Morgan report.

The Fed has already gone to great lengths to buy time — by cutting rates and coming up with new ways to boost liquidity. But it may be getting close to the limit on rate cuts, as it must also worry about sparking inflation. That conundrum has some analysts wondering whether the Fed is running out of ways to bolster market liquidity.

“The Fed has pulled almost every non-conventional rabbit out of the hat to provide liquidity,” notes Rosenberg. “But when we have a crisis of confidence on our hands over financial-sector balance-sheet quality, the Fed’s medicine — as [economist] Larry Summers recently put it — is akin to ‘fighting a virus with an antibiotic’.”

In other words, cosmetic but ineffectual.

There are other, more extreme actions the Fed could take to pump liquidity into the system. For example, Morgan Stanley notes that the Fed has the statutory authority to purchase government and agency securities and to pay for them by printing more money.

“Of course, such moves aren’t to be taken lightly,” its report says, pointing to episodes of hyperinflation that have been caused by reckless money-supply management in other countries throughout the 20th century. “However, inaction might represent an even more dangerous option if the situation continues to deteriorate.”

But the solution to the current market crisis probably lies well beyond what central banks can be expected to offer. “The solution is necessarily going to transcend the Fed,” Rosenberg suggests, “and inevitably require intervention by the federal government.”

According to a UBS Securities Canada Inc. report: “A more durable period of stability will not return to capital markets until U.S. policy begins to focus on the real issues of insolvency, capital adequacy and home-equity prices, rather than the symptoms [credit withdrawal, illiquid market conditions and bailouts].”

Indeed, while the Fed struggles to keep markets working, there are more fundamental policy prescriptions that are likely to come out of this crisis. There are plans afoot in Congress to address the underlying mortgage mess. Moreover, there are probably long-term changes in store for financial services firms.

A new report from the senior financial supervisors from several countries in Europe, along with several U.S. regulators, sampled the risk-management practices of some major global financial services organizations in an effort to find what distinguishes banks that have been hard hit by the crisis from those that have suffered little damage. The regulators pledge to use the results of their review to inform improvements to the Basel II capital adequacy framework.

Additionally, the president’s working group on financial markets — comprising the U.S. Treasury Department, the Fed, the Securities and Exchange Commission and the Commodity Futures Trading Commission — is recommending a host of changes for mortgage originators and brokers, credit-rating agencies, financial services institutions and various aspects of the securitization business.

Some of these policies could filter their way north of the border. According to a Desjardins Securities Inc. report, the group’s recommendations include a call for U.S. authorities to pressure other countries to make changes similar to those proposed in the U.S. This could mean changes to compensation practices at bank-owned dealers or a separation in funding between banks and their dealers. “If this happens,” the report says, “the implications for the investment industry in Canada would be far-reaching.”

But, as the global financial services industry has never faced a comparable crisis, it’s hard to point to a past episode to predict what’s in the industry’s future. IE