Is the Sky Falling? A Recap and a Prediction

As we push further into 2008 and see market conditions continue to deteriorate, the number one question that investors seem to be focused on is whether things have gotten bad enough to lead to a recession. Many financial experts seem to think so, but if we are heading in this direction, are the right actions being taken and what will this mean going forward?


The Sky
Photo:Hamed Saber, Creative Commons, Flickr

Hindsight says that the housing market received an unnecessary boost in the recent past, fueled by interest rates that were too low for too long. Banks and mortgage lenders took advantage of this favorable lending environment to create all sorts of exotic mortgages that subsequently allowed otherwise unqualified buyers to purchase homes. When these same home buyers could suddenly no longer afford their mortgage payments, foreclosures increased and all the investors who had thrown large sums of money into the subprime market got burned.

Investors still continue to feel the singe of this market meltdown and once-mighty financial institutions such as Countrywide Financial (CFC) and Bear Stearns (BSC) are being brought to their knees. The Dow Jones has dropped from over 14,000 to as low as 11,850.

In response, the Federal Reserve Bank has slashed the federal funds rate (now at 2.25%) and created a whole assortment of emergency loan programs to try to bail out the same sector that it was responsible for weakening.

Much-needed liquidity is being injected into the paralyzed credit markets at an unprecedented pace. This is the same liquidity that will help soften the subprime correction we are undergoing and should lead to eventual economic recovery. As we have argued before on thepanelist.net, the best policies in a time of crisis are those that address the cause, not the symptom.

The Fed is doing its part to try to restore order to the current market turbulence. Additionally, the Fed is playing a role in creating new legislation that will help prevent such crises from happening again. The cause of this mess is simply dried up credit markets. The symptom is the economic and financial market uncertainty that is gripping the country and starting to ripple across the globe.

The close-knit cadre of critics out there who claim that the Fed’s solution is short-term and will exacerbate the pressures we are seeing, may be forgetting that Rome wasn’t torn down (and rebuilt) in a day just as it wasn’t built in a day initially. The housing boom that many (unqualified) people enjoyed lasted for several years, much in the same way the full correction will not happen overnight.

The excesses of the market have to filter through and be wicked away before equilibrium can be restored. The effects of interest rate cuts generally do not surface until 2-3 quarters later, so we cannot be so quick to judge how this crisis is being handled. At the end of the year, however, I will be the first to issue a report card to our monetary overseers, as that is when I hope to see some of the strain lifted.

Taking it one step further are the doom and gloomers; those who say that enough damage has already been inflicted and that we are facing a long-term period of decline, which threatens America’s position as a superpower.

In the interim, the doom and gloomers argue that the Fed has become a house of cards, in that it has lost its power to control the financial markets, monetary policy has lost its effectiveness as a tool to re-establish market equilibrium, and it is only a matter of time before we need to majorly overhaul our central banking system. Our declining dollar provides evidence for this theory. Personally, I think it is way, way too early to opine this scenario. There is no need to panic yet.

What can investors expect?

Stay tuned for further discussion.

Disclosure: I do not own CFC or BSC.

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