What a relief! The House finally approved the $700 B rescue bill. While the sweetners added by the Senate may have helped, listening to the House debate I got the impression that many congresspersons changed their votes because the reality of the situation has started to dawn on them. The emails and the phone calls from the constituents have decidedly changed from vehement opposition to a mixed bag. Auto sales have shown significant declines, even Toyotas and Hondas are showing 20-30% declines in sales. Small businesses are reporting trouble meeting payroll and buying inventory as the credit has dried up. I have bankers reporting that they have stopped issuing credit in certain sectors believing them to be very risky, restaurants being one of them. Heck, even the State of California has been locked out of the credit markets, and surely many more states will feel similar issues
The problem is not of liquidity. Fed has been injecting tremendous liquidity in the market in the past few weeks. The problem is of trust (or so called counterparty risk in the street vernacular). Banks are not lending to one another because, frankly, they do not know if they should trust the other party. They don't know how much toxic assets the other party carries. The credibility of the rating agencies are shot. Businesses are still getting loans but the banks now require tremendous due diligence to conclude the deal. The wall to climb is much higher and in the process even relatively stable businesses are either shut out or they give up
Trust needs to be brought back to the system.
Fed now has a lot of work to do. While $700 B appears to be a great deal of money, it is pretty small if you consider the assets of the financial companies. It cannot realistically hope to buy out ALL the impaired assets. But what it can do is to start sending signals to the market in several different ways
Fed should start acquiring assets strategically and in a very visible way. This will help in the following way
- Get some bad assets off the balance sheets of the affected banks improving their capital position
- Start setting prices which are hopefully better than the current distressed levels. This would improve the market of these assets and allow the remaining assets with the banks to be revalued to a more realistic level
- Improving valuations of the underlying assets should help in unwinding the CDS bets in a more orderly fashion, as well as the cost of insuring CDS as well as the risk will go down which should help some insurers who have been hurt even though they do not really own any of the mortgage obligations directly. AIG comes to mind.
- Fed can hold the assets long term, even till maturity if needed. The banks cannot, as valuation swings affect their capital ratios
Another role that the Fed can play to bring Trust back to the system is to act as an intermediary counterparty when needed
I firmly believe that these actions would help the credit markets to normalize again. Will this mean that good times are coming back soon? Maybe not, but it does set a foundation for the business activity to restart in this economy and that should help ensure that the recession is going to be shorter lived than it would absent this rescue package
Final thought: I do not yet know how this package is going to be funded (if you have thoughts or knowledge, please share). But I would think that if this involves increasing the money supply, than we are probably in for some inflationary times. In any case, I would suggest my readers to pay particular attention to their personal finances and tighten up their belts and increase their savings. We are all in this together. Please feel free to visit some of the excellent personal finance blogs listed in my blogroll for ideas and support. And for the investing component for your savings plan, equities are still the best way to invest for the long term. More so now when a large number of businesses are undervalued. And a long term perspective helps.