Federal Reserve & Interest Rates

The financial system is at a fragile point and any delay by Congress in approving the bailout of the banking system could have dire consequences.  Lending institutions have been crippled by the credit crisis and their inability to sell illiquid mortgage assets that no one wants to buy.

The industry needs to consolidate but it is a tough time for mergers and acquisitions as the availability of capital is practically nonexistent.  There is a lack of confidence in the banking system and capital markets in general.

It’s going to become increasingly difficult for troubled banks to raise funds because investors don’t want to be left holding the bag when they fail.  They can’t sell stock and they can’t sell bonds and deposits can quickly dry up at the first sign of trouble.

A run of on bank deposits quickly doomed Washington Mutual and it was seized by federal regulators in the biggest failure of a banking institution in U.S. history.  Bank runs could be a common sight in the near future as the continuing troubles of the housing market lead to more losses by financial institutions.

The rate of mortgage defaults and foreclosures continues to grow as home prices keep falling.  Neither the Federal Reserve’s or the government’s actions have seemed to help other than possibly delaying the inevitable.

People are worried about their money and FDIC doesn’t have the capital reserves to pay for all the insured deposits of the growing number of troubled banks.  We could witness a staggering amount of bank failures in the upcoming year if the situation doesn’t start to improve soon.

Will the bailout be enough to fix the problems or is it too little to late?  Whatever happens middle class America is likely going to take it on the chin before this mess is all said and done.

The financial system has been choked off by a lack of liquidity in the form of mortgage assets that no one wants to buy.  Treasury Secretary Henry Paulson has brought forth a plan for the government to become a buyer of last resort.

These illiquid assets are clogging up our financial system, and undermining the strength of our otherwise sound financial institutions. As a result, Americans’ personal savings are threatened, and the ability of consumers and businesses to borrow and finance spending, investment, and job creation has been disrupted.

The federal government must implement a program to remove these illiquid assets that are weighing down our financial institutions and threatening our economy. This troubled asset relief program must be properly designed and sufficiently large to have maximum impact, while including features that protect the taxpayer to the maximum extent possible.

The plan would be an unprecedented bailout of the financial system that is estimated at a whopping $800 billion.  I think the government finally realizes that monetary policy can only do so much on it’s own and that a fiscal plan was also needed to head off financial disaster.

The problems of the financial services industry is slowly getting worse, this week saw three financial giants brought low.  The Fed had to issue an emergency $85 billion loan to AIG to keep it from a disorderly collapse, while in investment banking, Lehman Brothers declared bankruptcy while Merrill Lynch sold itself to Bank of America at a fraction of it’s former value.

The banking system is clearly in big trouble and I’m not sure if the Federal Deposit Insurance Corporation has enough reserves to insure the deposits of Americans from the growing number of banks that are in danger of failing.  Credit is being choked off at the source as banks are stuck with assets that they are unable to sell.

Financial institutions raised hundreds of billions of capital to deal with writedowns from the subprime collapse but they are loathe to loan that money out.  The big problem is that the financial sector is so intertwined these day that even relatively strong financial institutions are worried about counter party risk so they are hoarding capital to protect themselves for when their weaker brethren start to fail.

This plan definitely puts taxpayer dollars at risk but the alternative could very well be a financial Armageddon that could plunge the world into another Great Depression.

Despite yesterdays upheaval on Wall Street, the Federal Open Market Committee voted unanimously to keep interest rates at 2%.  The stock market was shaken yesterday, falling the most in a single day since the Sept. 11 bombings.

The downside risks to growth and the upside risks to inflation are both of significant concern to the Committee. The Committee will monitor economic and financial developments carefully and will act as needed to promote sustainable economic growth and price stability.

Yesterday, many traders were betting that the Fed were going to lower rates by a quarter percent but that just shows you how fickle futures trading can be, just last week everyone was betting that they were going to raise rates instead.  Keeping rates unchanged is probably the smart move despite what traders on Wall Street think.

Right now the Fed is playing the waiting game and seeing how the housing market will react to the aid package that Congress approved in July which included the rescue plan for Fannie Mae and Freddie Mac.  The Fed is in a difficult position, can housing markets recover while financial markets are unstable, can financial markets recover while housing prices keep falling and foreclosures and defaults continue to rise?

Yes, the Fed has some wiggle room to lower rates with oil prices falling the way they have but it’s still falling and they probably want to keep it that way.  Lowering rates could easily wash away the inroads the dollar has made in currency markets the last two months and we could then be right back to $150 oil again.

The bankruptcy of Lehman Brothers and the buyout of Merrill Lynch has brought into sharp focus that the financial crisis is far from over.  It’s still unclear what the repercussions will be from bankruptcy of Lehman, it was thought of as “too big to fail” but it has failed, so now what happens?

There is no easy fix for the problems the financial services industry is facing.  Companies that overextended themselves during the housing boom are just going to have to take their lumps during the long contraction.

While Fed won’t be lowering rates, they will most likely attempt to inject additional liquidity into the banking system once again.