The Gathering Storm

Conn Carroll /

According to Rasmussen Reports only 30% of Americans currently support a government clean up of the financial system. The reason why? 50% of Americans “say it’s better for the government to let the companies that made financial mistakes go bankrupt.” As a general rule, we agree with this principle. However, the current crisis on Wall Street will not be confined just to those firms that “made financial mistakes.” As we show below, the housing bubble has metastasized into a liquidity crisis that threatens everybody. Even those that have acted prudently are set to be punished.

Created decades before the New Deal, the Federal Reserve is the central bank of the United States. It is supposed to regulate the supply of money in the U.S. economy. The Federal funds rate is the primary tool the Fed uses to influence the rate of money and credit creation. The funds rate is the interest rate at which banks lend money to each other. The Fed controls the funds rate by adding or subtracting from the amount of funds available. As the chart below shows, last week the Fed lost control of the funds rate:

The spike and plummet at the end of the graph shows that no matter how much liquidity the Fed pumped into the system, banks were still unwilling to lend to one another. It is hard to imagine a clearer signal of extraordinary stress in financial markets. Financial institutions are so panicked that they are simply refusing to lend to one another.

This credit crunch is just beginning to spread throughout the economy. Financial institutions, investors, and firm are hoarding cash out of general fear. Many financial institutions are shutting down existing lines of credit to otherwise healthy businesses. Consumers will also be affected as banks make it more expensive to get mortgages and car loans. Not only will banks not offer home equity lines of credit, they will begin to demand payment on the lines they have out. Families that borrowed off of their home thinking they could pay it back over a span of years will be forced to come up with the cash immediately.

As the next chart shows everyone is now rushing to put their money in the safest possible place for the short term, Treasury notes. Here is a chart on spread between long- and short-term Treasury noted since September of last year:
The widening gulf between the interest rates on one and three month notes versus the rates for 30 year notes shows that the short term credit market has completely collapsed. At one point, investors were willing to pat $1.05 for $1.00 worth of Treasury notes. On September 30, an enormous volume of debt will come due as it is both the end of the month and the end of the quarter. Many firms will seek to roll this debt over as part of its regular cash management. If the credit crunch continues, many of these firms will be unable to roll over their credit creating a cash crunch inside the firm.

As a result, firms that have done absolutely nothing wrong will be forced to use their cash to immediately pay off their debt instead of paying off vendors and meeting payroll. Already, strong, solvent, prudent firms like Caterpillar and Honda are paying a premium for short term debt. Those increase costs will be passed onto consumers and employees.

This problem will only spread and get worse unless the federal government moves to clean out the financial system of all the bad housing related assets.