Credit Crunch Continued…

Reading a Reuters article this afternoon about what steps the Fed might take after it lowers it’s interest rate down to 0.50% (ludicrous), which is something i wrote about here a while back, this excerpt caught my eye…

The real problem today is that market interest rates that are built over the Treasury or Fed funds base — the rates at which real borrowers borrow and real lenders lend — now range from high to prohibitive. If we are to get credit flowing again, the spreads must come down — a lot. When the Fed buys commercial paper, guarantees GSE debt, or backs asset-backed securities, it is trying to reduce the spreads on each of these instruments over Fed funds or Treasuries. It should keep doing that.

Essentially what it is saying is that despite the Fed funds rate being close to zero, we are still experiencing a credit crunch due to private institutions lending off of that money at higher rates.

The way banks lend is (extremely simplified) they borrow from the Fed or each other at one rate (like the Fed funds or others) and lend it at a higher rate that they decide. Their profit comes from the spread, the difference between the interest rates they borrow and lend at.

What the banks are doing now though, because of the recession, the bad loans made in the past, the lack of new investment, and plain common sense, the banks are only lending to borrowers who can pay them back.

What this article is suggesting, and indeed what the Fed is doing, is to manipulate those interest rates by buying the securities that derive from the loans or insuring the loans against loss. Both of those decrease the risk to private lending institutions and encourage them to lend.

If those two things sound dumb or familiar it’s because they are.

Mortgage-backed securities are exactly what complicated and spread the housing crash, leading to losses by individuals and companies that had nothing to do with lending and just happened to own securities in otherwise respectable organizations that did.

And insuring debt against loss is exactly what wrecked AIG and could gouge Warren Buffet to the tune of $37 Billion. Because loans were made to entities that could not repay them and then were insured against loss and securitized is the essence of the financial crisis.

Banks don’t want to lend to anyone who can’t pay them back, because doing that is exactly what got us into this mess to begin with. If they do it again it’s just going to be the same situation. But now they don’t have to, the Fed will do it for them. The question is, what makes the Fed different?

They have unlimited money. The Fed can buy as much as it wants because it creates money out of thin air. It doesn’t matter how much loss the Fed takes on credit-default-swaps (insurance against debt) or bad loans or commercial paper or whatever.

Because the Fed can’t make private institutions lend any more by bailing them out or lowering the interest rates at which they borrow any further, they are bypassing them completely and doing the dirty work themselves. It’s perfect… it’s socialism.

There are two problems with that Utopian solution.

1.) Because money is being lend to those who inherently can’t pay it back, foreclosures will result. This will be hard and unnecessary for the parties involved but there is something else to consider. The Federal Reserve will undoubtedly end up with real assets essentially for free.

2.) Inflation. The money will be printed and sent out into the economy, bidding up prices and making all our lives a little bit more miserable and expensive.

What’s sad is this will work… depending on your definition of work. Eventually enough debt will get paid-off or foreclosed upon to make room for more and the cycle will begin anew. Another boom will rise up out of the ashes. But inflation looms and a little bit more real wealth will have been transferred out of the working people’s hands. It will be the end of this economy and country as we know it. Eventually.

But for now it’s rinse and repeat. We’ll be talking about the boom of 2015 and the recession of 2020 in no time.