Could the Credit Markets Seize Up?

And what would that mean for the stock market and the economy?

It’s something that worries me. Could the credit markets seize up? I mean, there are TRILLIONS of dollars of derivatives out there. And as you know, Bear Stearns is a market maker in mortgage bonds, a primary dealer in U.S. Treasury notes and clears or settles securities transactions for other brokers and investment funds.

Bloomberg had an interesting story this morning ...

Bernanke's Bear Stearns Bailout Breaks With Four Decades of Fed Policies

“As a governor, you never want to be placed in this position,'' said former Fed governor Laurence Meyer, who served during the central bank's coordination of the rescue of hedge fund Long-Term Capital Management LLC in 1998.

``Everybody has to be uncomfortable with this. But it is always, compared to what? Just imagine what would have happened today if this action hadn't been taken.''

I wonder just what Laurence Meyer is imagining.

By the way, remember how the market rallied Thursday when S&P announced that the big banks were near the end of their writedowns? Obviously, S&P’s statements can be trusted on this about as much as their ratings, which have shown to be completely untrustworthy.

And I point you to another story in the Wall Street Journal …

Debt Reckoning: U.S. Receives a Margin Call

The U.S. is at the receiving end of a massive margin call: Across the economy, wary lenders are demanding that borrowers put up more collateral or sell assets to reduce debts.

The unfolding financial crisis -- one that began with bad bets on securities backed by subprime mortgages, then sparked a tightening of credit between big banks -- appears to be broadening further. For years, the U.S. economy has been borrowing from cash-rich lenders from Asia to the Middle East. American firms and households have enjoyed readily available credit at easy terms, even for risky bets. No longer.

Interestingly, further down in the story …

while cash continues to pour into the U.S. from abroad, this flow has been slowing. In 2007, foreigners' net acquisition of long-term bonds and stocks in the U.S. was $596 billion, down from $722 billion in 2006, according to Treasury Department data. Americans, meanwhile, are investing more of their own money abroad.

And could we be approaching the zero hour for the dollar?

Pressures in one market spread rapidly to other, often more distant markets. "The dollar and subprime -- they're two sides of the same coin," says Princeton University economist Hyun Song Shin. Many U.S. hedge funds and financial institutions were speculating in mortgage-related securities with money that was ultimately borrowed in Japan, where interest rates have been low for years. He notes foreign banks' net liabilities in the yen interbank market surged between April 2006 and April 2007. As investments bought with money borrowed in Japan get sold and converted back into yen, he says, "we see both a fall in asset prices and a fall in the dollar."

Jimmy Rogers has an opinion on that …

"No country in the world has ever succeeded by debasing its currency," he said. "That's what this man [Bernanke] is trying to do. He's trying to debase the currency as a way to revive America. It has never worked in the long term or the medium term."

Back to the Wall Street Journal for one more comment ...

The resulting blow to confidence threatens to further weaken lending, borrowing, spending and investment in the U.S. economy. "Hedge fund blowups have so far been one-off situations. One worry is that we'll cross some line and there'll be a systemic wave of fund failures. It's a reason why the market is so nervous," says John Tierney, credit derivatives strategist at Deutsche Bank.

Here's a question for you: Could we be approaching the kind of financial crisis that forced Britain off the world stage after World War II. In its death struggle with Germany, Britain really spent itself into the poorhouse. Germany may have lost the war, but Britain lost the peace.

The US stepped into the vacuum created by Britain’s exit. Who will step into the vacuum if we leave? China, probably. Meanwhile, the US continues a slow slide into quiet desperation. Could China survive a global credit crunch; could India for that matter? There are too many variables, and I don’t know the “worst-case scenario” that Laurence Meyer has in mind.

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