Ron Paul’s email points out: F.A. Hayek won the Nobel (Myrdal - see previous comments) Prize in Economics for showing how central banks’ manipulation of interest rates creates the boom-bust cycle with which we are sadly familiar. In 1932, in the depths of the Great Depression, he described the foolish policies being pursued in his day - and which are being proposed, just as destructively, in our own:

Instead of furthering the inevitable liquidation of the maladjustments brought about by the boom during the last three years, all conceivable means have been used to prevent that readjustment from taking place; and one of these means, which has been repeatedly tried though without success, from the earliest to the most recent stages of depression, has been this deliberate policy of credit expansion.

To combat the depression by a forced credit expansion is to attempt to cure the evil by the very means which brought it about; because we are suffering from a misdirection of production, we want to create further misdirection - a procedure that can only lead to a much more severe crisis as soon as the credit expansion comes to an end… It is probably to this experiment, together with the attempts to prevent liquidation once the crisis had come, that we owe the exceptional severity and duration of the depression.

The usual strategies to start a rally were tried.

1. Jam the futures in the runoff (the 4 to 4:15 time after the cash market closes but futures and index options still trade).
2. Start a rumor of a Fed rate cut.
3. Pump up the tech stocks in the pre-market.

We’ll see if they work. In the meantime, GE warned of a poor quarter, unemployment claims jumped to nearly half a million and durable goods orders dropped by 4.5%. Rate cuts are really working, eh? In the meantime the bailout package is getting done, despite massive public opposition, to keep the “campaign contributions” flowing. If as much attention was paid to the real economy as is being paid to Wall Street and maintaining stock prices, we might make some progress.

Other than the usual outrage about private profits and socialized losses (entirely justified, but a waste of bits), I haven’t seen much analysis of the likely outcome of the proposals being outlined by the Fed and the Treasury. So I’ll try. First of all, the problem they are trying to solve is the lack of liquidity or reliable valuation of large amounts of debt owned by banks and brokers (and many others). This debt was originally valued by its rating from the various agencies, S&P, Moody’s, etc. These ratings claimed to predict default rates and loss severity, which allowed people to price the paper. The statistical models on which the ratings were built, however, turned out to be nonsense, basically because they assumed ever-increasing house prices. Which was in fact the case, throughout the period covered by the statistical database on which the models were based. Anyway, when the rating predictions had clearly been invalidated, no-one knew what the likely default rates and losses would be, and so no-one wanted to buy the paper without such a huge discount that that the risk was mitigated.

The owners of the paper feel that the bids for the paper are excessively low - and I’m sure they are, the potential buyers want to be confident of making a profit and the uncertainty is great. And if they sold the paper at those prices, it wouldn’t matter because they would be bankrupt. So they transferred the paper to the so-called “Level 3″ category, where they simply make up the valuation, and live in fear that the paper will actually trade, forcing them to mark theirs to the market price. The problem is that, given that large chunks of their balance sheet are of unknown value, almost certainly much less than that at which ithey are carried, no-one wants to deal with these companies because as recent events have shown (Bear Stearns, Lehman, AIG), they can claim financial health one day, and then literally disappear overnight.

So the government’s approach is to buy this paper from them, presumably at a price that leaves the companies in reasonable condition, and have the taxpayer shoulder any subsequent losses. Barney Frank of the House Banking Committee is already celebrating that this purchase of these obligations, together with its purchases of Fannie and Freddie, to say nothing of its takeover of Indymac, will allow the government to slow or halt foreclosures on the underlying mortgages, thus “keeping people in their homes.” Of course, if there is no foreclosure resulting from default, then defaults will surge and further devalue the mortgages underlying not only this paper, but the assets of the other government mortgage providers. Why pay if you can live for free, or at least reduce your payment at will? Not moral hazard at all, just a “business decision.”

We need to remember that we have been in a Ponzi bubble, where increases in debt have been used to service the existing debt, so the amount of debt outstanding has risen to historically unprecedented amounts. Total credit market debt now amounts to $50 trillion, or about 350% of GDP, according to the Fed. Of that, mortgages account for some $14 trillion. So the $700 billion cost of the bailout mentioned is not all that large, 5%, in proportion to just mortgage debt. On the other hand, it is quite large in relation to the current Federal deficit of about $410 billion for 2008. 

• The total amount is of the same order as the total level 3 assets (the most toxic waste) of the largest banks and brokers. It is therefore likely that the measures will allow the banking system to avert a liquidity crisis. This is a good thing. However, new credit will remain constrained and the amounts involved are insufficient to re-inflate the housing bubble. Housing prices will continue their decline and defaults will continue to increase, whether or not people are actually thrown out of their houses.
• Those level 3 assets are almost certainly overvalued in terms of their marks, but whether or not they are overvalued relative to their intrinsic value is unknowable. If you believe, as I do, that losses on this paper will continue to increase, it is reasonable to expect that the measures will be costly and significantly increase the Federal deficit. If other measures, e.g. another “stimulus package” or Mr Frank’s foreclosure moratorium are thrown into the pot for the election, then the cost will soar. This impact will show up in higher rates on government debt and other term credit, including mortgages, as competition increases for a shrinking or at best constant pool of credit.
• The negative impact on consumption from tight credit will continue. There is no scenario here which leads back to the recklessness of the last ten years. As I’ve said before, consumption has been boosted by the increase in credit and that won’t be happening. The impact of these measures will be to modestly slow the decline, not reverse it. This means that employment will continue to decline and incomes in the financial services industry are unlikely to return to the peaks of the Second Gilded Age.
• As the New York Times asks: “Most broadly, what are the long-term costs of the government stepping in to restore order after so many wealthy financiers became so much wealthier through what now seem like reckless bets on housing — bets now covered with public dollars?” No-one knows, but it is clear that the myth of free markets is now thoroughly debunked, and the rent-seeking of the financial services industry clearly exposed to any observer.

I’ve purposely avoided any opinion on the dollar, simply because other countries have similar problems and the outcome in a race to the bottom is hard to anticipate.
 

Two money market funds have now “broken the buck” as a result of holdings of Lehman paper that is more or less worthless. Got cash?

The real question is when are the hedge funds reined in because of reduced credit availability? Most of these guys use massive leverage. Any impairment of their access to credit could cause a wave of liquidation.

However, the actual worrisome thing today is the announcement that the Fed is directly monetizing the AIG acquisition, that it is printing money to pay for it. Inflation antennae are at full extension.

If it wasn’t so sad it would be funny. The idiot brigade is back to “we’re so going to get a rate cut tomorrow.” Well, we probably are. But it doesn’t matter. This isn’t about rates, it is way too late for that. The pundits touting the “second half recovery” are just missing the year, that’s all.

Ignored in the Lehman/AIG hullaballoo, industrial production fell 1.1% in August and capacity utilization is at levels historically seen only in recessions. Until the financial system returns to profitability and recapitalizes itself, nothing much good is going to happen, no matter what the Fed does. Manipulating the yield curve is way not enough to overcome the spiralling defaults.

This whole mess with the broker-dealers was 100% inevitable when they started to take them public and abandoned the partnership model. The employees ripped off the shareholders and took all the capital out as their compensation. Of course the public shareholders and creditors were going to get the short end when the staff no longer had any liability. When a newbie MBA who can barely run Excel is being paid $250K you know nothing good is going to happen.

Edit: NEW YORK, Sept 12 (Reuters) - Mohamed El-Erian, the chief executive of top bond fund Pimco, said on Friday that the U.S. banking system doesn’t have enough money to weather the current credit crunch related to massive mortgage-related losses.