Federal Reserve & Interest Rates

The government is hoping that the $250 billion it has earmarked to re-capitalize the banking system will be enough to jump start lending once again.  However the landscape of the banking system far different then it was when this all began.

Leveraged finance saw the explosion of credit in the past two decades, where that $250 billion could have easily become over $5 trillion in credit, if not more.  It would not have been surprising for many financial institutions to have leverage ratios of over 20.

During good economic climates this maximized profit potential but during the current financial collapse the opposite is now true.  Now institution are frantically trying to de-leverage themselves from more potential losses over and above what they have already lost.

Structured finance and the selling of collateralized debt took the credit market to new levels but with the failure of that financial model, there is serious doubts on how quickly banks will start lending again.  Nothing has really changed in the past six months, banks will still want to hoard capital and just because it’s from the government doesn’t change that fact.

The FDIC’s troubled banks list is enormous and more than likely any capital received from the Treasury will be used to stave off collapse.  Until they get their balance sheets in some kind of order, lending and the extension of credit will not be their primary concern.

We could quickly see the government’s involvement grow even further, as some analysts feel that the $250 billion which has been allocated to the banking system so far, is no where near enough what is enough to restart lending.  With another stimulus package in the works, how high will the government’s price tag eventually become.

During testimony before the Senate Banking Committee, Fed Chairman Ben Bernanke spoke in favor of further fiscal policy measures to stimulate sagging economic growth. 

Should the Congress choose to undertake fiscal action, certain design principles may be helpful.  To best achieve its goals, any fiscal package should be structured so that its peak effects on aggregate spending and economic activity are felt when they are most needed, namely, during the period in which economic activity would otherwise be expected to be weak. 

Any fiscal package should be well-targeted, in the sense of attempting to maximize the beneficial effects on spending and activity per dollar of increased federal expenditure or lost revenue; at the same time, it should go without saying that the Congress must be vigilant in ensuring that any allocated funds are used effectively and responsibly.  Any program should be designed, to the extent possible, to limit longer-term effects on the federal government’s structural budget deficit.

Consumer confidence has fallen in recent weeks due to instability in financial markets.  Fear of a long economic downturn has stifled consumer spending and has many Americans thinking about saving money.

The initial stimulus package propped up economic growth numbers in the second quarter this year and another such measure could help even more now that inflation and high energy prices are not as much as a concern.

Many retailers have made bleak forecasts going into the holiday shopping season and even if Congress acts fairly quickly on this, it will still take time for such a package to work it’s way through the economy.  Based on the effect of the first stimulus package, it could take between roughly four to six months once Congress approves such a measure before it will start impacting consumer spending numbers.

The economic challenges ahead will require both monetary and fiscal policy measures working in concert, if it is even possible to avoid a recession at this point.  That being said the government has had to act in reaction to each new economic crisis instead of acting to prevent them in the first place.

Federal Reserve Chairman, Ben Bernanke gave a speech earlier today at the Economic Club of New York where he discusses the current financial meltdown gripping the global economy.

The crisis we face in the financial markets has many novel aspects, largely arising from the complexity and sophistication of today’s financial institutions and instruments and the remarkable degree of global financial integration that allows financial shocks to be transmitted around the world at the speed of light.

Large inflows of capital into the United States and other countries stimulated a reaching for yield, an underpricing of risk, excessive leverage, and the development of complex and opaque financial instruments that seemed to work well during the credit boom but have been shown to be fragile under stress. The unwinding of these developments, including a sharp deleveraging and a headlong retreat from credit risk, led to highly strained conditions in financial markets and a tightening of credit that has hamstrung economic growth.

The root cause of our current economic dilemma has been the end of the housing boom and the subprime meltdown that followed.  Bernanke discusses how in the future, monetary policy can play a role in restricting the creation of asset bubbles and their subsequent effects when they burst.

He also touches on the why AIG was given government assistance while Lehman Brothers was not, AIG had the assets and collateral so that the likelihood of taxpayer liability was minimal, which was not the case with Lehman.  Even then AIG is responsible for a heavy burden in the high interest rate it must pay in order to secure that government loan.

As it should be, much of the liability in the case of AIG is in the hands of the shareholders as was the case with Fannie Mae and Freddie Mac when the government took control of those institutions.  It is probable that AIG will have to be broken up in order to repay the Fed loan but that might not be a bad thing in the long run.

We can expect to see increased regulatory oversight from the Fed as well as the Treasury in the future which will be a far cry from the two decades of deregulation that the financial system has experienced beginning in the 1980’s.  A major problem currently plaguing the economy is that companies have gotten too large and complex, when a company enters the category of “too big” to fail, they have the potential of creating large shocks to the financial system if and when they begin to disintegrate.

Large companies can hold a financial system hostage as was the case when Lehman declared bankruptcy.  Stock markets around the world have been feeling the shocks from that event, from which they have yet to recover.