Liquidity Problems Remain

On May 2nd, The Federal Reserve issued a statement about the crisis in liquidity which has bottlenecked global growth for several months. Since last August, banks have written down $300 billion in sub-prime related securities, but the IMF has predicted that the eventual cost will exceed $1 trillion. As major banks unloaded debt over the last half of 2007, their balance sheets became spread too thinly. As a result, they have become increasingly less willing to lend, especially to each other, preferring instead to shore up capital.

The resulting credit crunch has had a knock-on effect on the larger economy, prompting the US central banks to slash the key Federal Funds rate seven consecutive times in as many months, from 5.25 percent to 2%. This policy has resulted in flat or slightly negative real interest rates, but mortgage and other interest rates remain artificially inflated, thus mitigating some of the benefits. Another problem with lowering interest rates is that it is difficult to gauge their effects on market conditions, as they typically take some time to work their way through the financial system.

Indeed, while interest rates have taken most of the headlines, the central bank has also taken extensive action in direct lending to banks. The most well-known example of this marked shift in policy is the Fed-backed bailout of the troubled investment bank Bear Stearns earlier this year. The floundering securities firm had problems with one of its hedge funds in early 2007, leading up to a well-publicized meltdown in March as other banks became wary of lending to them. This eventually forced them to seek emergency assistance, resulting in their buyout by JP Morgan with a guarantee of funding by the Fed to the tune of $29 billion. By extending the so-called "discount window" to an investment bank, the central bank took a de factor role as lender of last resort, a privilege usually reserved for commercial banks. Whether they overstepped any boundaries is now moot, of course. Likely the ensuing panic upon the failure of one of the largest US banks would have been worse than keeping them afloat. Their decision has proven to help provide short-term stability for markets.

Despite regular injections of capital from the European Central Bank, the Bank of England, and the Federal Reserve, investors seem unsure that the end of the credit crunch is nigh. Inflation has reared its head in recent months, leading to global food riots and record gasoline prices. The weakening dollar has contributed greatly, as the oil-producing nations which price their exports in the US currency are forced to raise prices accordingly. Interest rate cuts are likely over for a long while, as the Fed tries to balance continuing liquidity issues with inflation. $600 billion in Fed-issued loans has covered much of the cost of the credit crisis so far, but IMF estimates are only applicable for the numbers used to make them. Unless banks are growing, building capital, or both, liquidity will continue to hamper recovery. It will take time, but restoring confidence for investors and lenders is the only way economic growth can resume.

Ki provides information and analysis on his site about Austin real estate along with providing a search of the Austin MLS. He also posts regular market updates on his Austin real estate blog.