As Credit Crisis Eases Why is the Economy Still a Mess?

After unveiling one plan after another to fix the seized-up credit markets, the Federal Reserve can claim some success in reviving lending for key groups of borrowers, reports Marketwatch.

It can't say the same of meeting its overriding goal - restarting economic growth.

Loosening up the commercial-paper market has allowed big companies like General Electric to sell bonds. Lending dollar-based funds to foreign central banks probably helped drive down the benchmark rate for many mortgages and commercial loans. And intervention in money-market mutual funds likely prevented a financial shock from turning into catastrophe.

But one year ago this week, when it guaranteed J.P. Morgan's takeover of Bear Stearns to stave off global financial chaos, the Fed embarked on a series of unprecedented interventions into private capital markets.

That marked the first and highly controversial step of lending money to broker-dealers from its discount window, putting them on similar footing with commercial banks. And over the next year, it repeatedly widened its role as a lender of last resort, accepting more illiquid securities as collateral for loans and buying corporate debt straight from companies.

So much talk of the "moral hazard" of propping up failures has largely disappeared. Consumer credit continues to contract and the Blue Chip survey of economic forecasters is predicting the worst recession since World War II.

"The problem has become more fundamental than liquidity," said Michael Feroli, U.S. economist at J.P. Morgan Chase & Co. "It's moved on to more of a solvency, capital problem."

So we're finally seeing the real problem emerge, which is that many companies are just plain broke. I've been saying this since this financial crisis started. Leveraged products can not just lose you money but can also lose you money you haven't got. What were balance sheet assets could turn into liabilities. And the Federal Reserve is doing its job of protecting its members - the banks.

A program to lend dollar-denominated funds to foreign central banks, through what's known as swap lines, has helped depress Libor, the London Interbank Offered Rate. The 3-month dollar LIBOR has fallen to 1.32% from a spike of 4.8% last October.

And one of the Fed's programs to prevent a catastrophic run on money-market funds seems also to have done its job. On Sept. 19 it launched the AMLF - shorthand for Asset-backed Commercial Paper Money Market Mutual Fund Liquidity Facility.

"The AMLF has been the single most successful government intervention to date in the financial crisis," said Peter Crane, editor and publisher of Money Fund Intelligence.

The Fed says it's also made headway in the mortgage market, where rates have slid after its late-November announcement that it would buy $600 billion in mortgage-related bonds. Fixed-rate mortgages due in 30 years are about 1 percentage point lower than they were in November, according to Freddie Mac, although they have started to rise in recent weeks.

Success for some of these programs has created high expectations for the Fed's latest program, the $1 trillion Term Asset-Backed Securities Loan Facility, or TALF. That plan aims to jumpstart issuance of securitized credit-card receivables, auto loans and student loans.

It's considered an important response because of the role institutional investors played in the past several years in extending credit.

"We need to support the primary banking system in the country, but we also need to support what [Treasury Secretary] Tim Geithner calls the shadow-banking system - the securitized market, which has really gone silent," Miller of T. Rowe Price said.

Bernanke has described the Fed's policy as a "credit easing" designed to increase the supply of credit to households and businesses, thereby restoring "economic prosperity as quickly as possible."

Programs to help the interbank-lending, commercial-paper and mortgage markets are working, he has said, as evidenced by lower Libor, commercial paper, and conforming mortgage rates.

But for the broader goals of reinvigorating economic growth, the Fed's efforts have come up short so far.

"The Fed can create liquidity, they can't create solvency," Mueller said. "They can't take a bad loan and make it into a good loan."

The rapid expansion of the Fed's balance sheet has prompted some critics, such as Philadelphia Fed President Charles Plosser and others outside the Fed, to warn that the central bank is overreaching. Critics worry the central bank is taking on too much credit risk and say its intervention in private markets threatens a cascade of negative, unintended consequences.

Looking at all these Fed plans the scenario unfolding becomes clearer. Toxic debt is being turned from private hands into public ones that will ultimately be paid for by all taxpayers. The companies that constructed various debt instruments are frantically trying to plug up the losses on their books with help from the Fed. However, the ultimate borrowers, the mortgage holders, credit card holders, auto loan holders etc, are going to take the fall. Just look at the difference between mortgage rates and LIBOR rates. Mortgage rates just have not come down so the lenders are hoping to make a lot of money here that they can use to offset other losses. With job losses rising the individual is going to be bled dry.

Protect any wealth you still have. Also, calculate if you are going to be in trouble repaying debts any time soon. Just as the moral hazard associated with bailing out companies is in the rear-view mirror so it should be for individuals. Do whatever you can not to get sucked in further... for I fear this is going to go on a lot further.