Goldilocks woke up

Our Economic Dilemma By MARTIN FELDSTEIN

[T]he subprime mortgage crisis demonstrated that financial risk of all types had been greatly underpriced, that the market prices of complex financial assets overstated their true values, and that the credit scores provided by rating agencies are not to be trusted. [Yeah, well, duh.]

[P]ast recessions were caused by deliberate Federal Reserve policy aimed at reversing a rise in inflation.

In contrast, the real interest rate in 2006 and 2007 stayed at a relatively low level of less than 3%. A key cause of the present slowdown and potential recession was not a tightening of monetary policy but the bursting of the house-price bubble after six years of exceptionally rapid house-price increases. [And exceptionally lax Fed policy.]

[T]he principle cause for concern today is the paralysis of the credit markets. Credit is always key to the expansion of the economy. The collapse of confidence in credit markets is now preventing that necessary extension of credit. [So lower rates won't cure it.]

Securitization, leveraged buyouts and credit insurance have also atrophied. [Plum wore theyselves out from excess, Guambat reckons.]

The lack of confidence in asset prices also translates into a lack of confidence in the creditworthiness of other financial institutions

[F]inancial institutions do not even have confidence in the value of their own capital

It is not clear what can bring back the confidence

Some analysts suggest that confidence would return if the financial institutions declare the true market value of their assets by restating balance sheets at the depressed prices at which they could be liquidated today. But this is not a practical solution, since many complex securities are no longer trading in the market. Forcing an actual sale of these securities at fire-sale prices in order to establish market values could also create unnecessary bankruptcies that would further impede credit flows.

[This is exactly what Guambat tried to tell his broker when the broker insisted on more margin. Why does the argument sound so reasonable when it is the broker/banker making the argument than when it is the wretched little guy??]

There is plenty of blame to go around for the current situation. The Federal Reserve bears much of the responsibility, because of its failure to provide the appropriate supervisory oversight for the major money center banks.

The Fed's bank examinations are supposed to assess the adequacy of each bank's capital and the quality of its assets. The Fed declared that the banks had adequate capital because it gave far too little weight to their massive off balance-sheet positions -- the structured investment vehicles (SIVs), conduits and credit line obligations -- that the banks have now been forced to bring onto their balance sheets. Examiners also overstated the quality of banks' assets, failing to allow for the potential bursting of the house price bubble.

The implication of this for Fed supervision policy is clear. The way out of the current crisis of confidence is not. We can only hope that those who predict nothing worse than a temporary slowdown are correct.