How is the Fed Chairman handling the credit crisis? What could he do better?

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Well as many are aware, the country is in a bit of a credit crisis at the moment. A few years of very VERY low interest rates prompted a housing boom that was out of proportion with typical family incomes as more and more families purchased homes. Instead of purchasing homes they could afford, many individuals took out loans they could not afford, they did 80/20 loans, ARMS, interest only loans and a host of other loans that are not typically a smart move for the consumer.

Last week the Fed Chairman Bernanke injected about 30 billion dollars into the market in an attempt to restore some liquidity to the markets. His hope was it would be enough to encourage slightly looser credit terms for qualified persons and businesses. This had only a minor affect on the overall credit markets throughout the US. The last couple of weeks it has become more and more clear just how big this sub prime credit problem is and how it has unexpectedly affected virtually all credit markets including those qualified for the very best loans.

This led to the Fed coming out and saying that if, and its a big IF, but if it is necessary he will cut the rate from 5.25 to 5.0%. This in and of itself has been viewed by many to be a good thing. Some thing we should already be lowering rates, Jim Cramer, of CNBC's mad money has been going batshit insane over this subprime lending fiasco and the credit crunch. When not six weeks earlier he was begging people to get into the market because we were going to experience a vast boom. He is not the only one trumpeting the emotional bandwagon. Others throughout the media are doing the same thing, adding an element of fear that probably shouldn't be there. It will be interesting to see their reactions after the Fed said he would be open to lowering rates.

In the Fed's most important and symbolic move to date he lowered the discount rate. The discount rate for those who do not know is the rate charged by the Fed for direct to bank loans. These loans are also only a one day loan under normal circumstances and yet Bernanke extended these loans to a full 30 days. The discount window is typically a one day loan because the fed does not want banks borrowing money unless it is absolutely necessary to cover their reserves requirement. Not many banks take these loans because if word got out on the market it could be devastating for the bank. If it is a public bank then it would be out on the market and would be viewed as a sign of weakness by shareholders and clients alike. Banks should always have the money on hand to cover their reserve requirements. So as you can see, lengthening this loan term to a full 30 days is substantial. It signals to the banks, the markets, investors and other businesses that the Fed is paying attention to the markets and it opens the door for longer term loans. These loans have the potential to help banks turn a quick buck for the next 90 to 180 days on a recurring 30 day loan from the Fed. By lengthening this term to 30 days the fed is hoping to encourage banks to use the discount window. It would be an opportunity for many banks to bolster their bottom line IF they can shake the stigma associated with fed borrowing.

Potentially the big benefeciaries of this are not necessarily the large banks like BoA or CitiGroup and its affiliates but the smaller mortgage specialists and companies that purchased many of these subprime mortgages. While its not all bank problems that are the source of our current liquidity, helping the banks should help alleviate the pressure in other areas of the economy that are currently experiencing this pinch.

In reaction to this news the markets went up drastically on Friday, at one point the DOW was up 300 points. It finally settled up 233 points, while the broad S&P 500 finished up 34.67 points. While markets are not always indicitive of economic performance this move should not only restore economic stability but should also help drastically in improving investor confidence in the coming weeks/months. At least that is the hope of the Bernanke and the Federal Reserve.

I personally believe this is a fantastic move by the fed. They have gone out of their way to try to assure the markets, businesses, banks and the American people that they are paying attention. They are in touch with the US economy. Core inflation has been kept in check and while economic growth has slowed it has been due to the meltdown in housing and residential construction. The broader economy is doing pretty well, however, if this issue gets substantially worse it will spill over to the rest of the economy. If things get worse the fed will have no choice but to begin lowering interest rates. I personally would only do that as a last resort. The rates are still only moderate by historical standards and considered low by many who remember the ridiculous rates of the 70s and early 1980s. The problem is Greenspan lowered rates too much which led to a large boom in housing. Lowering rates again could prove to only prolong the pain. If rates are lowered I believe they should not go lower than 4.0% in the next 9 months or so. Doing so could push inflation higher and create a false floor for housing that will eventually come down. This subprime crunch looks to only worsen over the next year or so as ARMs and other non traditional loans are defaulted on by individuals who in reality, never should have taken the loans to begin with.

Thoughts on what the fed could or should do?