Friday, September 12, 2008

Echo Chamber
The Wall Street Journal today echos my concerns from last night. The government's attempts to stop the credit crisis have not stopped it, and its options are shrinking. Here is a long segment from the article detailing what the government is up against:

U.S. officials are not powerless to confront the crisis. But they are far more constrained than they were a year ago, after taking a series of steps to bolster financial markets, including slashing interest rates.

The Fed now has facilities in place to provide short-term funding to firms such as Lehman if it runs into a liquidity crisis. As of Wednesday, no firms had used the Fed's lending facility for investment since late July.

"A number of markets remain disrupted and illiquid," the Fed's Mr. Kohn said Thursday. "But I believe that they would have been even more illiquid and the risk of disruption runs even greater without our various facilities."

Doing more could lead to other problems. Fed officials are wary of pushing short-term interest rates lower. At 2%, the federal-funds rate is 3.25 percentage points lower than it was a year ago, and looks likely to stay on hold because the Fed worries that more rate cuts would worsen inflation. What's more, other interest rates, such as mortgage rates, remain elevated as previous rate cuts have been counteracted by the force of the credit crunch. It's not clear that further cuts would have much effect in bringing down other rates.

Officials are also acutely aware of the problem of "moral hazard." Bailing out too many firms, the reasoning goes, would encourage more risk taking in the future. That makes officials reluctant to be seen as rescuing another institution. The Fed made a $29 billion loan to help J.P. Morgan take over Bear Stearns. It's not clear that it would be willing to do that for another firm.

Treasury Secretary Henry Paulson has said that institutions must be allowed to fail and that markets can't expect the government to lend money or support every time there's a crisis. "For market discipline to constrain risk effectively, financial institutions must be allowed to fail," Mr. Paulson said in a speech in July.

I think the problems lie in two areas - housing and credit. If the Fed lets interest rates fall this will help the housing market, which in part, will ease the deleveraging process. I think lower rates, at this point, out weigh inflation concerns because the falling dollar and declining oil prices should ease inflation. I have said this before, but any home loan today is going to be a heck of a lot better in terms of asset quality and borrower credit quality than most loans banks made from 2002 through 2007 .

The second part, credit, is institutions lending to other institutions, individuals and corporations. The lemming mentality has inflicted the financial world. The world's business runs on credit, much of it short-term. Banks and other credit sources have constrained the credit process. The inability to rollover short-term debt, or get other sources of credit, is and will have profound impacts on the economy. This was proved in the whole auction rate debacle when banks suddenly stopped rolling over a credit facility used by many municipalities. It made no sense. While I don't see a return of the free flowing credit, some level of normalcy would help ease the credit crisis.

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