Saturday, November 29, 2008
The Fed has engaged on a path of “quantitative easing” (defined in Part II of this report), which has only been tried by Japan, where it was met with limited success. Success rests on the hopeful, but possibly flawed, assumption that cheap money will lead to renewed borrowing.
Understanding the mechanism and implications of this requires an appreciation of the credit markets, what they are, and how they operate. In Part I we discuss the credit markets and the extent to which the government is now a credit market participant. In Part II we examine the Fed’s chosen strategy of fighting the collapse in lending activity with the tool of quantitative easing, and what this could mean for you.
Often, the present financial crisis is misrepresented in the media as being one of bad loans dragging down the balance sheets of unlucky banks. Justification (or political rationalization) for the extravagant loans and outright gifts to the major banks rests on the false implication that if their past losses were covered, then “normal” bank lending would resume, and all would be well again. Insofar as this is a regretfully incomplete view, it is false.
Actually, the crisis extends well beyond a breakdown of the ability of banks to lend, and encompasses a breakdown at every stage of the system of lending and borrowing. This is also called “the credit market” and is comprised of three broad classes of participants:
- Debt Issuers: This category includes banks and other lenders (such as auto loan and credit card companies) that originate debt for consumers and corporations. Sometimes the debt is issued at the same time that an asset is acquired (mortgages and auto loans), and sometimes the debt leads to cash being exchanged for a note.
- Intermediaries: These are the middle men that trade in debt instruments, making money either by transforming them (as in the case of the securitization process where subprime mortgages were bundled and resold) or by merely trading the debt. They typically pay themselves by skimming a little off of each transaction.
- Debt Holders: This group is made up of the funds and investors that purchase the debt instruments and hold them to maturity, collecting the interest income and principal payments along the way.