Friday, February 15, 2008

The Central Problem We Face

Bernanke spoke to Congress yesterday. Here are some key points from his speech.

As the concerns of investors increased, money center banks and other large financial institutions have come under significant pressure to take onto their own balance sheets the assets of some of the off-balance-sheet investment vehicles that they had sponsored. Bank balance sheets have swollen further as a consequence of the sharp reduction in investor willingness to buy securitized credits, which has forced banks to retain a substantially higher share of previously committed and new loans in their own portfolios. Banks have also reported large losses, reflecting marked declines in the market prices of mortgages and other assets that they hold. Recently, deterioration in the financial condition of some bond insurers has led some commercial and investment banks to take further markdowns and has added to strains in the financial markets.

Let's go back to out basic model of the US economy:

As the chart demonstrates, the US financial system is at the center of the economy. It acts as a financial intermediary between lenders (individuals' assets pooled together) and borrowers. The financial system must be healthy for the economy to prosper.

But it's not. More importantly, Bernanke clearly knows what the the problems are. At a time when lower interest rates should be increasing the total amount and value of loans, financial companies are also reporting increasing losses, a diminishing asset base and the addition of poor performing assets to their respective balance sheets. In other words -- financial companies have a ton of really bad assets on their books which prevents them from making new loans.

BTW: Bernake is a convenient whipping boy for me. I think he is making a boneheaded mistake right now by lowering rates and signaling he will lower further. Inflation is far higher than he thinks and lower interest rates aren't having the effect he wants.

However, despite me vociferous disagreement with Bernanke, he's a bright guy and no one should doubt his ability.