A Well-Timed Weekend

Terry Connelly is dean of the Ageno School of Business at Golden Gate University and is frequently quoted on business, financial, and economic issues by Bay Area local, as well as national, news media.

What’s going on in the volatile US equity market and bond market is the long-deferred adjustment to the bursting of the housing bubble. That bubble occurred in large part though a corruption of credit standards brought on by the temptations associated with a prolonged period of cheap money (1%) which itself was thought necessary by Alan Greenspan’ Federal Reserve to cure the effects of the dot.com bubble and share market crash in 2001.

This repricing of risk is made more complicated by the fact that the financial instruments devised to facilitate the corruption of credit standards so diffused and obscured the locus of ultimate liability that it is extremely difficult to now value those instruments in the wake of the surge in foreclosures on the underlying mortgaged properties. As Don Rumsfeld remarked in another quagmire context, it’s the “unknown unknowns” that get you — in the current credit crunch, we are experiencing the mother of all information gaps in the Age of Information!

Basically, we don’t really know what the balance sheets of scores of financial institutions really amount to — and this in turn makes it harder for them to assess what to charge each other for the millions of overnight lending transactions which are at the core of the modern global financing system.

That overnight lending rate (the “Federal Funds Rate”) is what the Federal Reserve tries to set to a level that it believes will both discourage inflation and encourage sustainable economic (and employment) growth over time. Just right now, the free market rate has been adding a steep risk premium to the Fed’s targeted 5.25% interest rate, and has forced the Fed to enter the market itself to bid down the cost of overnight money by pumping cash reserves into the system. While this is a tried and true, textbook response to a” credit crunch” , it remains to be seen if it will prove to effective both in technical terms as well as in terms of calming trading market anxieties.

The weekend cannot come too soon. Credit liquidity is the lifeblood of the economy, and a transfusion (however Federal) does not always help when the problem is at root hypertension! The financial system’s blood pressure is up fundamentally because it doesn’t know what it doesn’t know about the state of financial institutions’ balance sheets, and it will take some time to find out. Everyone (including now the SEC as well as CNBC) is trying to get the true picture.

One question, for example, is whether the banks putting margin calls to hedge funds invested in the sub prime and near-sub prime mortgage markets because their investment collateral is now deemed to be radically lower in value if not worthless, are holding themselves to the same standard in “marking to market” the same investments they hold on their own balance sheets!

What will happen over the weekend? A lot of number-crunching in the finance offices of global financial institutions and funds; the market “adults” will be called back from the beaches to take charge of the trading desks (because the whole year’s bonuses are now truly at stake as share gains since January are evaporating).

Some, like the young Kevin Bacon’s soldier at the raucous conclusion of Animal House, will stand in front of the onrushing crowd and plead that “All is Well”.  But Jim Cramer and others (Merrill Lynch, for example) will step up calls and predictions that the Fed lowers the Funds Rate, if only as a dose of monetary ativan to relieve the tension of the unknown.

And the question will surface whether this whole unraveling of a corrupted mortgage credit structure will in the end yield the serious “recession we had to have” (but did not have) post the dot.com crash.