Federal Reserve & Interest Rates

 Treasury Secretary Henry Paulson sat down with Jim Lehrer of PBS in a candid interview where he defended the implementation thus far of the $700 billion rescue plan.  Much of the problems the economy is currently facing built up before he took office but he along with Fed Chairman Ben Bernanke are in charge of dealing with the crisis.

I have always said that at the heart of the problem is the housing correction. And until the biggest part of the price decline in houses is behind us, we will have stresses in the financial markets and in the economy.

And I can’t give you a date for when that’s going to get better. But I can tell you, because we’re dealing with that, and we’re dealing with that as effectively as anyone can come up with an idea, stabilizing Fannie and Freddie, and while we’re dealing with that, we sure as heck better stabilize our banking system, which we did.

If people think the financial system is going to return to normal in a few short weeks, they are sadly mistaken.  No matter how much money we throw at the problem, things only seem to get better for a little while until something else goes wrong.

That something right now is a potential auto industry collapse, which could cause over a million job losses and could see a worsening unemployment rate shoot towards 10%.  Paulson so far, has been reluctant to use funds from the rescue package as some from Congress have been clamoring for.

With nearly half of the $700 billion allocated thus far, it will take Congressional approval for the release of the second half of those funds.  A major portion of that money now plans to be focused on consumer lending rather than the buying up of illiquid assets which was the original plan.

Why the change now? Well, you give all this money to the banks but you don’t know if they are going to lend it out, use it to cover future writedowns or what.  I think that’s why they went for the capital for equity route in the beginning, it gives the government more say on how they use those funds.

As staggering a number $700 billion seems, it can’t fix the problems of the banking system overnight.  The fundamental way banks have done business over the past decade is out the window.

The financial system has stabilized somewhat but the failure of the originate to distribute model of put a serious dent in credit generation and no amount of capital is going to bring that back anytime soon.

The Treasury is scrapping plans to purchase illiquid mortgage assets and will switch it’s focus for what’s left of the $700 billion aid package to the consumer side.  They want banks to start lending again and a number of federal agencies are teaming together to try to just that.

The agencies expect all banking organizations to fulfill their fundamental role in the economy as intermediaries of credit to businesses, consumers, and other creditworthy borrowers. Moreover, as a result of problems in financial markets, the economy will likely become increasingly reliant on banking organizations to provide credit formerly provided or facilitated by purchasers of securities. Lending to creditworthy borrowers provides sustainable returns for the lending organization and is constructive for the economy as a whole.

I think they are finally starting to see the bigger picture.  Nothing is going to get better while the housing market is still in the dumps.  People need to be buying homes and banks need to be lending them the money to for things to get better.

The foundation of the banking system is the people, they are the ones who are depositing the money and they are the ones who need access to that credit first.  With consumer spending making such a big chunk out of GDP, you can’t choke off the roots and expect the economy to keep growing.

They can’t concentrate on keeping individual companies from failing, that’s just going to get expensive fast and really won’t help matters in the long run.  They need to start at the base and work their way up.

We are already seeing the start of this as a number of companies have instituted mortgage restructuring programs in attempt to slow climbing foreclosure rates.  The growing number of bank owned properties only serves to swell supply and damp down prices even further.

The global effort to re-capitalize the banking system is slowly paying off and interbank rates are starting to fall once again.  But the damage has already been done and it will take time for the economy to recover from last month’s financial shocks.

In the meantime consumer spending is expected to take a huge hit in the next few quarters and the faster the government can get consumer lending back on track the better off we will be.

The financial crisis which began last fall has pushed fiscal and monetary policy to the limits.  Government spending has exploded over the past year to the tune of nearly $2 trillion for just the economy alone and if anything it’s been picking up speed lately.

When the Federal Reserve made it’s initial $85 billion loan to AIG it imposed a crippling interest rate which was at 8.5% above LIBOR.  However in conjunction with a new $150 billion aid package to the struggling insurance giant, the Fed has announced new terms to the original agreement.

The Federal Reserve Board and the U.S. Treasury on Monday announced the restructuring of the government’s financial support to the American International Group (AIG) in order to keep the company strong and facilitate its ability to complete its restructuring process successfully. These new measures establish a more durable capital structure, resolve liquidity issues, facilitate AIG’s execution of its plan to sell certain of its businesses in an orderly manner, promote market stability, and protect the interests of the U.S. government and taxpayers. 

It makes sense, the first loan would have ensured an untimely liquidation in order to pay it down as quickly as possible and that wouldn’t help anyone.  But the price tag keeps going up and up.

Banking, insurance and now the auto industry wants in.  GM could very well go belly up and over a million jobs lost if it doesn’t get funding before the year is out.

There appears to be support for a bailout but nothing is ever certain, remember the $700 billion bank rescue plan failed to pass the first time around.  The Treasury also doesn’t appear to be willing to use any of that money for the auto industry so any help will have to come from somewhere else.

Maybe there will be no help for the auto industry, the government is obviously willing to make tough, cold hearted choices when it has to.  AIG got a loan from the Fed the same day Lehman Brothers got the cold shoulder and declared bankruptcy. 

The housing market need serious fixing and huge amounts of money are going to have to be poured into Fannie Mae and Freddie Mac if that’s going to happen.  Americans might also get some relief in the form of a new stimulus package before the next administration even takes office. 

The new government is going to have it’s hands full coping with this financial mess and will most likely be aggressive in tackling the problem at the start and that just means more and more spending but what else can they do.  This has the makings for a long economic downturn and no one knows how long it will last but one thing is certain, the longer it does, the more expensive it will be.