Sep 25, 2008

Bailout already off to a bad start :
Credit Crisis
Banks Bog Down
Liz Moyer, 09.25.08, 3:30 PM ET

Washington appears poised to rescue the banking system with a $700
billion bailout, but are banks ready to help themselves?

Judging from activity (or, rather, non-activity) in the credit markets
Thursday, the answer is not quite yet.

The difference between rates in the overnight lending markets and
rates in the longer-term markets, a gap that is widening, suggests
banks aren't willing to lend much to each other. That is the type of
activity needed to break the logjam in the credit markets.

The Federal Reserve has been flooding the banking system with cash, so
much so in the last week that it has pushed the effective overnight
interest rate below the central bank's target 2%. On Thursday it
announced a $20 billion reverse repurchase program with banks to try
to narrow that gap.

Meanwhile, the London interbank offered rate, which is the rate at
which banks lend to each other, continues to rise. The three-month
Libor is at 3.77%, according to UBS, and the difference between that
and the overnight rate suggests "interbank lending is broken," said
William O'Donnell, the head of U.S. interest rate strategy at UBS.
Rather than extend credit for longer than overnight, banks appear to
be hoarding cash.

"I hope the Fed has a lot of thumbs, because there is water breaking
through the dikes everywhere," O'Donnell said.

Expectations rose Thursday that the Fed could jump in with a rate cut,
either on or before its next scheduled meeting in late October.
According to the futures market, the expectation of a cut jumped to an
85% chance, from a 30% chance just last week.

The tumultuous events in the credit markets last week and this week
"give the Fed cover to go ahead and cut rates," says Aaron Smith, a
senior economist at Moody's Investors Service's

The grim news in the credit markets has been overshadowed by euphoria
in the stock markets, which rallied Thursday on news that Congress was
near agreement to approve Treasury Secretary Henry Paulson's $700
billion bank rescue plan, with revisions.

How else to explain a 300-point rally on a day when new-home sales in
August showed an 11.5% decline, a 17-year low, and General Electric
(nyse: GE - news - people ), a market bellwether, cut its forecast and
suspended stock buybacks because of a bleaker outlook for its
financial services business?

Signs of stress abound. According to data released by the Federal
Reserve Wednesday, short-term debt known as commercial paper
contracted by $61 billion over the last week and $113 billion over the
last two weeks, a period marked by the bankruptcy of Lehman Brothers
(nyse: LEH - news - people ) and the government rescue of American
International Group (nyse: AIG - news - people ).

Companies sell commercial paper, which is essentially a short-term
IOU, to fund daily cash flow activities, like payroll. Financial
companies use it to fund pools of car loans, student loans and the
like. A contraction in the commercial paper market suggests either a
lack of buyers or a lack of lending, or both.

Standard & Poor's said in a worst-case scenario, defaults on junk
bonds of non-financial companies could rise to 23% between now and
2010, which would make the next three years the worst period since
1981. Consumer-sensitive sectors--such as consumer products, media and
entertainment, and retail and restaurants--will be among the worst
hit, S&P says, in line with what happened in 1990-91.

The Fed and the Bush administration have been scrambling to shore up
the banking system or, at the very least, put a floor under the
housing market, which the banks' fate hangs on.

In July Congress passed sweeping plan to boost the housing markets, or
at the very least stop the bleeding. Just a couple of weeks after
that, however, the government had to rescue mortgage finance titans
Fannie Mae (nyse: FNM - news - people ) and Freddie Mac (nyse: FRE -
news - people ) with a $200 billion bailout. Then, in a three-day
span, Lehman failed; Merrill Lynch (nyse: MER - news - people ),
fearing a funding crunch, sold itself to Bank of America (nyse: BAC -
news - people ); and AIG had to be taken over.

In testimony to the Joint Economic Committee Wednesday, Fed Chairman
Ben Bernanke cast a grim assessment of the near-term economy. "Ongoing
developments in financial markets are directly affecting the broader
economy through several channels, most notably by restricting the
availability of credit," he said.

The $700 billion bank rescue effort, in which the Treasury will buy up
toxic assets from banks in the hopes of kick-starting the credit
markets, will help bank balance sheets, but that doesn't mean banks
will play along.

Banks lend when they feel confident, and when they are making the
profits that allow them to expand their business. The industry is in
contraction mode at the moment. "Once spurned, twice shy," UBS's
O'Donnell said Thursday. The Treasury's lending program and other
attempts to jump-start the economy "are the first bricks laid in what
is likely a very long path for banks and the economy," he added.