Credit Crunch

A reader of this blog sent me the following question and asked me to address it on the blog:

“Given the quick rise of the economy and mortgage company/loan issues; does it really make sense to continue to cut rates in an effort to try and prevent recession or are we trying to prevent a problem that needs to occur and we are merely postponing it and potentially making it worse?”

I think this is a great question and I would like to discuss it.

First I want to address the problem he is referring to. In mid July the Dow Jones Industrial Average peaked at about 14,100. Over the last seven weeks the index has dropped to about 13,300.

The drop is almost entirely due to consumer fears about the default on various consumer debts; especially the “sub-prime” segment of the US housing market. The default rates have increased and many investors, banks, and hedge funds have bailed out of the entire “sub-prime” lending industry. A huge number of US lenders have declared bankruptcy; a large number of Americans have lost their jobs due to this.

Even though the problem is entirely located in the US debt markets, stock exchanges around the world have fallen. This fall has occurred worldwide because so many different organizations own part of this debt that is now in danger of defaulting.

Housing prices have been affected as well. The price of homes in the US is falling.

Second let’s look at what has been done to combat the problem. Private industries around the world stopped loaning money to the US lenders that they feel are affected by problem. There have been a couple of weeks where even the BEST credit risks in the US could not have secured a home equity loan with a large national lending company. I think it is fair to say that the lending industry is going to come under a lot of scrutiny and it is going to be more difficult to secure loans. I imagine the idiots in Congress will put even more regulations on an industry that is already heavily regulated.

The Federal Reserve (And other banking institutions around the world) have poured a couple hundred billion dollars into the system in an attempt to ensure that there is enough “liquidity” for banks to make loans.

The Federal Reserve has cut the “discount rate” .5% on August 17th. This is the rate at which the Federal Reserve loans money to banks and lenders. This was done to encourage banks and lenders to borrow more money so that they could in turn loan it to consumers.

The problem as it stands can be summarized fairly easily:
1. The US Government has emphasized home ownership and has encouraged all
Americans to secure loans for homes.
2. Lending organizations have made it easier and easier for Americans to
borrow money.
3. Americans have borrowed larger and larger sums of money. In fact interest
only loans have become common. Americans are paying smaller and
smaller down payments on their houses. Variable rate mortgages are very
common.
4. Many Americans are falling further and further into debt. This has caused
many to start defaulting on their mortgage payments.
5. This has caused more homes to be put on the market as banks foreclose.
Currently there is a large supply of houses on the market.
6. This has caused home prices to drop because of supply and demand.

There are more factors involved; however, this is a basic summary.

The original question I was asked is “Given the quick rise of the economy and mortgage company/loan issues; does it really make sense to continue to cut rates in an effort to try and prevent recession or are we trying to prevent a problem that needs to occur and we are merely postponing it and potentially making it worse?”

In my opinion our economy is a “house of cards.” Consumers, local, State and Federal government all have a record amount of debt. The entire economy is driven by consumer spending and Government spending. Government spending is rapidly rising; however, if there is a “credit crunch” consumers will not be able to purchase as many items.

I think our economy will get through this “credit crunch.” I expect that we will enter a small recession in either 2008 or 2009. I think that the “Fed” will be able to control the current “credit crunch.”

I am against any of the following:
1. More regulations on the lending industry.
2. Any Federal bailout of businesses.
3. Any Federal bailout of consumers who got loans they cannot afford.

What do you think?

Mike Sylvester