I was going to post a very in depth description of what is going on in the markets but on second thought it's not that complicated. So I'm going to keep it very simple.
The Federal Reserve, largely under the command of Alan Greenspan has kept interest rates far too low for far too long. That's in it a nutshell. It all goes back to that.
By keeping interest rates low, the Fed was the cost for prime banks to borrow money from the Fed very cheap. As a result they borrowed lots of money. That money works its way through the financial system by way of cheap lending to hedge funds, mortgage companies, credit card companies, etc from these prime banks. Because the rates to borrow money were low, asset prices went up. Think of it this way, if everyone can get a hold of lots of money and they bid for an asset the price will go up. As an example housing prices went up because it was so cheap to borrow the money to buy a house.
The natural effect of this is to increase leverage. Or increase the amount of debt an entity has. People bought homes that were way too expensive for their income levels. Hedge funds levered up and way too many assets. Investment banks did the same thing.
At some point that money cannot be so cheap to borrow. You don't get something for nothing. We were borrowing that money ultimately by borrowing from other countries or printing more money. Both lead to higher inflation which is the number one reason why oil prices are so high in the US. They also in effect sell a piece of the asset known as the US to those funding countries. At some point inflation will be too high so you can't print any more money or those countries won't fund you with any more debt so you can lend it out to prime banks or some of the assets or debt start to deflate. All three of these things are happening to some extent.
The only way out is to delever. Consumers are starting to do this. They aren't buying large homes any more. In fact they couldn't if they wanted to. No one will lend them money at cheap rates any more. Consumer income was up 0.5% this month and spending was flat. People are spending less than they are making creating a net savings. They are deleveraging. Those that can't will go bankrupt. Investment banks are highly levered and have been trying to sell their assets to pay off their debts. But they can't find anyone to buy any of their assets at a price which will ultimately pay of their debts. They are out of money and going bankrupt. Insurance companies which invest insurance premiums in assets are finding their assets are going down in value and are trying to maintain a certain amount of equity but they can't find anyone to lend to them and they are going bankrupt.
So what is the Fed doing now? They are trying to lend $700 billion dollars to flood the system with more money. Just as leverage creates money flows, deleverage sucks money out of the system. The Fed is trying to put money in to feed that deleveraging. I personally don't think this will work. To much liquidity got us into this mess and more won't help now. The only way out is to let the weak players die. In the case of investments banks they have all effectively died. And that's the way it should be. They were hedge funds and bad ones at that. Their true investment banking businesses and sell-side business are fee generating businesses and those will continue. But the hedge fund part, which was most of their earnings, is history.
The Fed may end up passing the bill but that will just postpone the inevitable. The deleveraging will continue until it's at a more reasonable level. Mortgage companies (Wamu, Wachovia, etc.) are largely gone. I think insurance companies are in the middle of it right now. I think the next level of distress will show up in hedge funds. This will be hard to see since they aren't heavily regulated and there aren't any good statistics. The last place it will show up is in pension funds. I believe you'll hear about massively underfunded pension plans on the state and federal level including some companies like IBM and the auto companies. And then we'll be done.
Well, done with the financials at least. It will still permeate through the country. Consumers will start paying off credit cards and mortgages and stop buying homes and expensive meals and fancy pans from Williams Sonoma. And the companies that service those consumers will continue to suffer. And restaurants will go bankrupt and retail stores will go bankrupt and the companies that sell things like servers and HR services to those companies will get hit and so on. And eventually we'll right-size the capacity in the system and only the best companies will be left standing. And then we'll grow again. I think we need at least 5 years to do this but I'm leaning more toward 8-10.
This is capitalism. This is what we signed up for. It's the best way to allocate resources. There are ups and downs. One should invest for the ups and be prepared for the downs. Any attempt to eradicate the downs by stopping short selling or pumping more liquidity into the system through the Fed prolongs this agony. Did the naked short selling or ban on shorting financial stocks stop them going down today? Go ask Japan about trying to cover up a market failure. They are still working through the detritus of their banking collapse. Go looks at their stock market. In fact go ask Alan Greenspan who pulled us out of the last tailspin in 2000 by injecting huge amounts of liquidity into our economy. Our market is no higher now than it was back then. We have to pay the piper at some point. It's better and more efficient to do it quickly and without pulling punches and to spend government money helping those at the very bottom. And as a result the US will be a far more efficient and powerful economy in the future.