Personal Finance Advice

The Fed looks like it’s willing to pull out all the stops during the current financial crisis but despite all that, a tight credit market will continue for some time.  Financial institutions will remain cautious with their capital until the final costs of the sub prime mortgage collapse is fully realized.

The lesson of Bear Stern’s near collapse fresh in their minds, financial institutions are hoarding their cash waiting for the next round of write downs.  Banks are reluctant to enter into long term loans when they might need those funds in the near future to meet margin calls or otherwise suffer Bear’s fate. 

Securitization allowed banks to transform a bundle of illiquid loans into a series of liquid securities tradable on secondary markets.  Demand for any sort of collaterized debt has pretty much dried up, making it difficult for banks to roll over their loans.

Credit can be quite difficult to obtain these days for both individuals and corporations.  Mergers and acquisitions have slowed to a crawl due to lack of financing.  This also has an effect on business spending as many companies are having to delay work on capital projects.

The Fed may have slashed interest rates but mortgage rates still remain relatively high.  Even those with good credit ratings are finding it tough right now.  It’s hurting demand in an already weak housing market and will delay any sort of recovery.

Many analysts are predicting that the tight credit market will most likely continue past the end of this year and into the next.  Even if the economy doesn’t go into a recession, it will slow to a crawl for some time.

Starting in the 1970’s, the banking system has undergone a long cycle of deregulation.  The culmination of all this was the repeal of the Glass-Steagall Act in 1999 which has since muddied the distinctions between banks, securities firms and the insurance industry when they began a period of consolidation.

The arguments for deregulation was to foster a climate of competition, innovation and lower prices by lessening government oversight and allowing  market forces to dictate the flow of credit.  Since then financial sector has experienced a rapid expansion by offering many new products and services.

After this current financial crisis is over, I think we can expect things turn back the other way.  While the collapse of the housing bubble was the main cause of our current economic troubles, no one can deny that the financial sector has it’s fair share of the blame for all this.  Lax lending standards and excessive risk taking through the explosive growth of securitization and derivatives has created a highly leveraged financial machine that is at it’s breaking point.

Unfortunately because the financial system is so intertwined now, market forces can’t be allowed to reach their ultimate conclusion, the collapse of a large number of financial institutions, no matter how much they deserve to go out of business.  The Federal Reserve has had to step in and use powers it hasn’t needed since the Great Depression in order to keep the banking system from collapsing.

One thing is for certain though, the larger the final cost to taxpayers, the more lawmakers will call for an increase of regulatory oversight of the financial services industry and that might not necessarily be a bad thing.

Economists were surprise on Friday when the Labor Department released inflation figures for the month of February.  The Consumer Price Index remained unchanged for the month after it was expected to rise by 0.3 percent.

The report could open the door for a full percentage point rate cut when the Fed is scheduled to meet on Tuesday.  Futures traders had been betting on a 75 basis points cut but many were increasing their bets for a full point cut after the report was released.

However, inflation is still a concern, with oil trading above $110 a barrel and gold breaking the $1,000 an ounce mark for the first time ever.  The fact remains though that with core prices remaining virtually unchanged, it does allow the Fed to act more aggressively in it’s policy initiatives in the near future.

The situation in the credit markets may force the Fed to do just that.  On Friday, the Fed along with JPMorgan moved to provide emergency funding for Bear Stearns Co., preventing the imminent collapse of the nation’s second largest underwriter for mortgage backed securities. 

It was a break in tradition for the Fed, which normally doesn’t interact with non-traditional banks in this manner.  However, desperate times call for desperate measures and the collapse of the investment bank would have sent shock waves through the entire financial sector.  With many firms struggling in a ever worsening credit crisis, the Fed may have to act again in the future to prevent the failures of other financial institutions.

There is a fear that this is a bad precedent being set, that firms can invest irresponsibly, only to hold out their hands to the Fed in their times of need.  Nonetheless the Fed had to act in this case because the alternative would have been unthinkable.