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September 30, 2008

A Market In Hope And Fear

by Doug Mataconis

As I speculated earlier this evening, it seems clear that today’s apparent bounce back in the stock market is based more on hope that reality:

It seemed, by many accounts, a far happier day than the last.

Hours after their worst drop since 1987, stocks reversed course on Tuesday and headed right back up on hopes that lawmakers were nearing an agreement on a bailout for the financial system. The Dow industrials jumped 485.21 points, erasing more than half its loss from Monday. Bank stocks rose sharply, investors were lured out of Treasury bonds, and the dollar soared.

But alarms were sounding elsewhere in the byzantine channels of the global financial system, sending a clear message that the health of the world’s economy remained at risk of worsening.

Even as President Bush and Congressional leaders worked to make a rescue plan palatable to lawmakers, the flow of credit neared a standstill, making it more difficult for businesses to obtain the money they need for routine expenses like utilities and payroll. Banks were still reluctant to lend, despite billions of dollars of cash offered up by central banks around the world. Early on Tuesday, banks were charging one another the highest overnight borrowing costs ever recorded, as measured by an important rate known as Libor.

Even the triple-digit stock rally, spurred by investors’ hopes that Congress will approve a revised version of a bailout plan, represented yet another of the big daily swings that reflect fragility and fear.

“This remains a volatile market,” said Quincy Krosby, the chief investment strategist at the Hartford, a financial services firm. “It remains a market that will move on headlines, on rumor. And it’s a market that has divorced itself from fundamentals.”

But even as the market bounced back, there were signs that the flow of credit was tightening significantly:

[P]roblems in the credit markets were widespread on Tuesday, making it more difficult for businesses and consumers to obtain financing, and driving down the value of assets held by money-market funds.

The interest rate on one-day commercial paper — usually a cheap source of financing for businesses — jumped to 3.95 percent, from 2.24 percent on Monday, pushing up the cost of these short-term loans.

In a sign that banks were increasingly unwilling to lend to one another, the Fed funds rate that they charge each other to get overnight loans to finance day-to-day operations, jumped as high as 7 percent on Tuesday morning — well above the Federal Reserve’s 2 percent target — before gradually falling back.

In the money-market world, institutional and retail investors appeared to be seeking more safety by transferring cash to funds that invest only in government securities, considered among the safest. From Sept. 15 to Monday, $372 billion, or 19 percent of their total assets, flowed out of prime funds. That reduced the amount of money available to corporations that count on these investors to purchase their short-term notes, which help supply their daily cash needs.

“The money markets have completely broken down, with no trading taking place at all,” Christoph Rieger, a fixed-income strategist at Dresdner Kleinwort in Frankfurt, said. “Central banks are the only providers of cash to the market; no one else is lending.”

One of the more emphatic arguments that I’ve seen over the past week from people who support the bailout, whether they be pundits, politicians, or economists, is the idea that we need to do this to reassure lenders who are tightening up on credit because many of them are overexposed to mortgage loans, and mortgage-backed securities, of questionable value given the collapse of the housing market. If lenders don’t lend because they’re afraid to, the argument goes, the entire economy will grind to a halt.

Now, there is a certain truth and logic to this argument. A lot of lenders are stuck with a lot of loans that may go belly up in the coming weeks or months. Because of that, they are being much more conservative in their lending practices already. If they tighten up even more, than it’s entirely possible that the economy could be pushed into a deep recession.

But, that doesn’t necessarily mean that at a $ 700 billion bailout is the right solution to our problems.

As I noted on Monday, the bailout bill would not solve any of the problems that we’re facing today, it would not eliminate the pain that will be felt thanks to years of easy credit and easy money policies by the Federal Reserve Board, Congress, Fannie Mae, Freddie Mac, and the rest of the banking industry. All the bailout will accomplish is to spread that pain throughout the economy and delay into some unknown point in the future the day of reckoning that must come for the mistakes that have been made. If the bailout happens, it may mean that the rest of this year, and the next several years will be better than they might have other wise —- but it will also mean that the dollar will continue to fall in value, inflation will increase, federal spending will go up even more than it already has, and the budget deficit and national debt will continue to soar. Someone will pay the price for that, and if the Federal Government takes ownership of the mortgage debacle, that someone will be the American taxpayer.

I honestly don’t think many people are thinking that far into the future, though. The markets are operating based on an insane combination of hope and fear, and the politicians are being guided by the same psychology into passing a bill not because they think it might work, but because they hope it will.

That, my friends, is a recipe for disaster.

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  • http://thelibertypapers.org/ Brad Warbiany

    “If the bailout happens, it may mean that the rest of this year, and the next several years will be better than they might have other wise —- but it will also mean that the dollar will continue to fall in value, inflation will increase, federal spending will go up even more than it already has, and the budget deficit and national debt will continue to soar.”

    Doug, you’re missing the point. That is the goal. The goal is to spread this out over different segments of the economy over several years, hoping that the pain will be diffuse enough that the economy will grow its way out of this eventually.

    Being in government during a time of severe pain is a bad deal. It’s much better that they leave us with several years of a dull ache, which they’ll hide through inflation. Even better (for them), they’ll have the opportunity to dramatically grow their own power in response to the “failures of the market” which they’ve stepped in to solve, as the “rescuers” they are.

  • http://www.belowthebeltway.com Doug Mataconis

    Brad,

    I completely agree with you on that point, I just wish the rest of America would realize what’s going on.

  • http://www.portfolio.com/resources/executive-profiles/Chris--Hutcherson--163960 Chris Hutcherson

    Now that the Senate has passed the 700 billon bailout has Obamas destiny been sealed?

  • http://www.orderhotlunch.com Jeff Molby

    Well said, Brad. I’m going to quote you on that.

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