Credit Market Brain Freeze

On Monday, after the House of Representatives rejected a $700 billion bailout of the US financial sector, stocks and commodities joined hands and jumped off the proverbial Wall Street window ledge. The Dow plunged to its biggest one day drop ever. Commodities also plunged the most ever, led by energy and grains. A notable exception was gold, which moved higher as investors clung to an island of stability in the storm-tossed financial seas.

Crude oil and gasoline plummeted around 10%, while corn and soybeans dropped the most allowed by the Chicago Board of Trade.

“Perhaps the most important trading week since the Great Depression lies ahead as world governments try to prevent a loss in confidence in the financial system,'' one trader was quoted in Bloomberg News. The spreading global credit crisis “could cripple growth for years to come and send world trade spiraling into an abyss,'' he said.

You know that I was no fan of the original Paulson plan. However, through the diligent work of Congressional leaders on both sides of the aisle, it had changed into something that, while still not a good plan, was perhaps workable. The goal is to stop the credit markets from freezing up. If the short-term commercial debt markets stop functioning, there are companies across America that simply won't be able to make payroll.

Today, in Bloomberg, we read:

"This is unheard of, the money markets should be the engine driving the financial system but they have broken down,'' said Kornelius Purps, a fixed-income strategist in Munich for UniCredit Markets and Investment Banking, a unit of Italy's largest lender. "Any institution that hasn't completed its 2008 funding needs by now is going to be in very serious trouble. More banks are going to need to be bailed out.''

and from the same article ...

"The money markets have completely broken down, with no trading taking place at all,'' said Christopher Rieger, a fixed-income strategist at Dresdner Kleinwort in Frankfurt. "There is no market any more. Central banks are the only providers of cash to the market, no one else is lending.''

My take -- I don’t think it’s the end of the world. It’s best to remember that panic is usually followed by a bottom (but perhaps not THE bottom). Now that doesn’t mean we’ll find a bottom this week. But the howls from the trading pits in Chicago and Wall Street are rousing the Washington leviathan from its feeding trough. While the first attempt to re-flate the credit markets failed, there will be other attempts – perhaps as soon as the end of this week.

So what kind of plan do I favor? Well, some examples are here, here and here. Or maybe something completely new. I'd especially like to see the FDIC raise the limit on insured individual bank accounts to $250,000 from $100,000 and an injection of $500 billion into the FDIC insurance program. These two measures should stop a run on the smaller banks in the US that are otherwise healthy.

I don't think there's time to go back to the drawing boards before the election. However, that doesn't mean we can't see bailout-plan induced rally soon. Just to give you one example how that could happen, former Labor Secretary Robert Reich thinks we’ll get a much-reduced plan and soon. He writes:

Prediction: A scaled-down bill will be enacted by the end of the week. It will provide the Treasury with a first installment of $150 billion. Treasury can use it to back Wall Street’s bad debts with no-interest loans of up to two years, until the housing market rebounds. Or to invest in Wall Street houses directly, in exchange for stocks and stock warrants. There will be strict oversight. Congressional leaders will promise further installments, but with conditions calling for limits on salaries and relief to distressed homeowners.

My take-away is that the market is being moved by politics more than fundamentals right now. And it’s very tough to chart politics.

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