The Credit Problem

Two weeks ago Monday, markets traded down 300 points at the open. The sell-off seemed to be in anticipation of what was widely considered to be a poorly thought-out bailout plan. As it became clear that the $700 billion package was not going to be approved by the House, the Dow Jones Industrial Average plummeted another 500 points. Stock jockeys had apparently decided that a bad bailout would have been better than none.

Fast-forward to the end of last week: During Friday’s House vote, the Dow rallied 300 points . . . but once the bill passed, they promptly reversed and sold off. It’s been more or less straight down ever since. Since the highs of October 2007 one year ago, the Dow has lost 39%, or about 5,500 points.

How did this happen? Why are markets reacting so negatively to a near $1 trillion bailout? The short answer is that the Federal Reserve and the Treasury Department have been focusing on the wrong issues. They have been treating falling asset prices—houses, stocks, bonds—as well as the lack of confidence between banks, as the actual issue. This is the wrong approach. Falling asset prices and a lack of confidence are a result of the underlying problem. You don’t cure alcoholism by getting rid of a hangover; you cannot resolve confidence issues by merely cutting rates.

The primary problem is that banks are refusing to extend credit to each other. Why? Because they do not understand the liabilities of their counterparties. Translated into English, that means they don’t know if the other bank whom they are dealing with will still to be standing tomorrow. The thing roiling markets today is not the lack of confidence; It is capital, or more accurately, the lack thereof. Thanks to a series of very poor trades—excessively leveraged and absurdly risky to boot—banks are now dramatically undercapitalized.

As we have seen in just about every historical financial crisis, the shortage of capital is the underlying cause of monetary mayhem. Too much debt, too little equity,makes any financial system cease to function...

from the Big Picture