Our Economy is in Trouble

Posted by jerry as credit crunch, finance

In the past 24 hours, Bank of America has announced that it entered into an agreement to acquire Countrywide Financial.  That’s an amazing thing.  Countrywide holds north of 20% of mortgages in the US.  As the housing market continues to unwind, they are seeing an increasing number of delinquent payments.  Despite this, Countrywide has to continue to pay the investors who funded a given mortgage until a disposition has been reached on that mortgage - either a new payment plan can be established, the borrower pays up, or the mortgage goes into default.  Normally, a company like Countrywide would tap a line of credit to help cover any difficulties.  These days, though, extremely few investors want to buy debt.  So,  Countrywide sits in a position where it is exposed to the point where it may have to file for bankruptcy protection, which will cause a further unwinding as it’s credit rating deteriorates.  BoA can be seen as a white knight coming in to provide a stable foundation for Countrywide to continue operations.   For it’s part, BoA needs to protect the $2B investment is previously made in Countrywide.

Clearly, this is a signal that we are in trouble.  The market is clearly looking to the government to ride in and save the crumbling economy with a stimulus in the form of a rate cut.  The fed futures rate currently predicts a 50 basis point cut before their next meeting, and another 50 basis point cut at the meeting.  We know that the market is hanging it’s hat on this as we saw yesterday during Big Ben’s speech.  Part of the speech had apparently been leaked shortly before it began, and a certain comment about the fed being willing to take action to help stimulate a recovery was taken out of context, causing the market to rise dramatically.  The market then fell as the statement was read and the real intent was clear.

Here’s the issue: interest rates arguably got us into this position and we are expecting it to get us back out.   The government has a set of levers that include:

• Overnight, inter-bank interest rate - the “fed rate”
• Interest rates on fed-backed borrowing - the “discount window”
• Taxes
• Deficit

It can be argued that the “taxes” and the “deficit” levers are broken at the moment.  President Bush was out this week touting more tax cuts, but they seem like a hollow rattle coming from a lame duck president with an opposing congress.

So, what will lowering rates do?  Arguably, not a lot to solve the actual problem we are experiencing.  In a NORMALLY FUNCTIONING economy, lower rates would stimulate spending, corporate mergers, capital investment, and so on.  But, we can observe that investors are so wrapped up in bad press of credit markets that it seems unlikely that the past trends will apply.  We would likely experience more of the negative consequences of lower rates than positive.  The negative consequences being inflation.  Unfortunately, we have an inflationary headwind blowing against the US economy that really is not linked to the US economy.  We have seen most commodities double or triple in price over the past 24 months., largely driven by the growth of other economies, and to some extend, growing speculation through vehicles like ETFs.  The inflation caused by lowering rates will only be additive to the existing pressures.

What caused the credit markets to go to hell in the first place?  The obvious answer is a misread by the fed when it chose to being a rate rising campaign many quarters ago.  Certainly, a slower rise in rates would have allowed some of the unwinding we are seeing to occur over a longer time.  However, the REAL cause was the lowering of rates earlier in the decade.  We call ourself a “free market”, but then when things get tough, our government feels that it has to intervene to artificially keep the economy propped up.   That is a recipe for disaster.  The kind of disaster that we’re watching now.  The government needs to remove the Federal Reserve Bank from it’s set of levers to control stimulus to the economy and use it only for what it is intended - to control inflation.  Absolutely, doing so will cause many years of pain and recessions, but once the market is able to find it’s own way, we will have a much more stable environment.  We have to let free markets be free.

In the wake of the “credit crunch”, we are going to see things get much worse as the problems move away from housing and to general consumer credit.  We know that the US economy is largely driven by consumer spending, and we also know that US consumers spend out of debt.  On a macro scale, what happens when consumers do not have vehicles to use debt to spend with?  A sharp correction will have to result.  Certainly, it’s not going to fall off of a cliff.  Many factors will prevent that - lowering interest rates, foreign investments, etc, but we should expect that John and Jane Doe will be spending less time at the Wal Mart that before.  This is particularly true as unemployment starts to rise and key commodities like food and gas become much more expensive.  In the recent past, we have had an offset to such things from rising property values.  We no longer have that offset.

From the standpoint of an investor, it looks like a great opportunity to buy into the market.  Just like it’s a great time for someone to buy a house.  We will get through this, but it’s going to be a wild ride for the next few months.