Federal Reserve & Interest Rates

Treasury Secretary Henry Paulson has put together a rescue plan for Fannie Mae and Freddie Mac that is expected to be passed by Congress sometime next week.  He has acted quickly in making sure there isn’t a run on the company after reports surfaced last week of financial troubles for the two government sponsored agencies.

There have already been quite a few critics to Paulson’s rescue plan, some calling it a “blank” check by the government that could possibly put taxpayers on the hook for up to a trillion dollars if not more.  The two companies are involved in about 50% of the $12 trillion mortgage market so there is a ton of potential liability that the government is being exposed to.

Proponents of the plan are confident that taxpayer dollars will not be put at risk since once investors are sure of the government’s backing of the two companies.  The implicit result would be that the government would pretty much guarantee that the two companies would not be allowed to fail and would do much to bolster investor confidence in both their stock and outstanding debt.

Financial advisors have quickly moved to rate the companies’ debt as a buying opportunity as they would essentially have the backing of the U.S. government and thus having similar risks as Treasury securities yet offering higher yields.  The stock prices of two have also recovered somewhat and have led to a strong rally for financials the last two days.

This would allow the them to quickly raise large amounts of capital in a short period of time, despite the fact that based on fair value accounting rules the two companies could be categorized as insolvent.  Although they claim they aren’t having liquidity troubles currently, the housing market is steadily growing worse and that additional capital may be needed sometime soon.

Federal Reserve Chairman Ben Bernanke testified before the Senate Banking Committee in his semi-annual Monetary Policy report to Congress.  In a sharp turn around from June when he claimed downside risks to growth had diminished, the recent turmoil in financial markets has led the Fed to abandon the economic forecast it made just last month.

At present, accurately assessing and appropriately balancing the risks to the outlook for growth and inflation is a significant challenge for monetary policy makers.  The possibility of higher energy prices, tighter credit conditions, and a still-deeper contraction in housing markets all represent significant downside risks to the outlook for growth. 

At the same time, upside risks to the inflation outlook have intensified lately, as the rising prices of energy and some other commodities have led to a sharp pickup in inflation and some measures of inflation expectations have moved higher.  Given the high degree of uncertainty, monetary policy makers will need to carefully assess incoming information bearing on the outlook for both inflation and growth.

In light of the increase in upside inflation risk, we must be particularly alert to any indications, such as an erosion of longer-term inflation expectations, that the inflationary impulses from commodity prices are becoming embedded in the domestic wage- and price-setting process.

For the last couple of months speculators believed that the central bank would raise rates by September but the deepening crisis for financial markets leaves many in doubt whether they will raise rates at all this year.  That means higher energy prices will remain largely unchecked and the prediction of $180 a barrel price for oil by year’s end could be quite possible.

The housing market isn’t getting any better and many financial institutions are stuck with mortgage assets that nobody wants.  The financial sector has already raised hundreds of billions of dollars in capital to cope with writedowns from the subprime collapse but how much more can they realistically raise before investors get tired of throwing good money after bad?

Imagine how bad the economy would really look right now if it wasn’t for the economic stimulus payments that went out in May.  Consumer spending is being sustained by that right now, but that tap will be running out in another couple of months.

Basically the Fed isn’t going to worry about inflation until people’s paychecks start going up like the price of everything else is.  So while large financial institution will garner most of their attention, middle class America will remain the big loser during this economic downturn.

In a speech today, Treasury Secretary Henry Paulson called for new regulations to help liquidate failing firms without it affecting overall market stability.

“For market discipline to constrain risk effectively, financial institutions must be allowed to fail,” Paulson said in excerpts of a speech he will deliver in London.

“It is clear that some institutions, if they fail, can have a systemic impact, so we must give regulators the authorities to limit that impact and facilitate an orderly failure,” Paulson said.

Why are these regulatory changes needed?  Well back in March, the Fed intervened when it looked like Bear Stearns was in danger of failing, financing a buyout from JP Morgan and putting to risk potentially $30 billion in taxpayer dollars.

Through it’s excessive risk taking in the residential mortgage market, Bear Stearns deserved to fail but it couldn’t be allowed to due to the impact it would have on other financial firms.  Financial firms are tightly interconnected these days through counterparty risk in the credit derivatives market, a largely unregulated market that has had explosive growth in the past decade. 

It is a massively leveraged market that has the potential of causing financial Armageddon according to some well known industry leaders.  Although firms are slowly de-leveraging, there will still be the potential of a failure cascade as the credit crisis is far from over. 

Over the past few weeks speculation has run wild on Wall Street that Lehman Brothers would meet the same fate as Bear Stearns and need to be sold at a discount, although those rumors have abated somewhat recently.  While this is one potential trigger that has been avoided, the danger will likely exist as long as home prices keep falling and firms face the prospect of more writedowns.