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The Unfolding Credit Crisis

August 14, 2007

Tags Booms and BustsFinancial MarketsInterventionism

With the collapse in the price of sub-prime mortgage backed securities and credit derivatives, the credit boom has moved into the crisis phase. This is the place in the cycle where it becomes clear to the market the investments made possible by unfunded credit were mal-investments and they are re-priced.

The initial response of the Fed and mainstream media was that the sub-prime crisis was small and would remain "contained" without spill-over into the rest of the financial system. An Austrian would have a reason to doubt this because the mortgage debt markets are so large, and because credit is so central to all economic calculation. It would be difficult to have a credit expansion in the mortgage markets that did not affect other credit markets, and economic calculation generally, which must always balance the value of present versus future goods.

Now as the crisis begins to affect banks, hedge funds, and equity markets, how will the political system respond? By allowing the corrective process to wring out the bad investments and return to a base for sustainable growth? Or by more inflation in an attempt to sustain current asset prices? The latter, it seems. The "government-sponsored" enterprises Fannie Mae and Freddie Mac were instrumental in creating the mortgage bubble in the first place, as Doug Noland explains in his weekly commentary. But as they were found several years ago to have engaged in questionable accounting practices and fraud, they have been increasingly reigned in by regulators and forced to stop adding to their portfolios of securities.

The Financial Times reports in Democrats Call for Action on Mortgage Crisis that powerful senators are calling for limitations on the GSEs be relaxed so that they may purchase a greater quantity of mortgage-backed securities from the banks and hedge funds that must sell them to meet margin calls. initial reports indicate that the GSEs will not be unleashed at this time.

Their status as "Government-Sponsored" means in effect that any profits they make accrue to their share holders (including their executives, who are well-compensated with stock), while losses are implicitly underwritten by the Fed's unlimited ability to print money. They are in effect a minor branch of the Fed.

The financial media has reported over the past week of central banks "injecting" money into the system to prevent liquidation of securities.

Central banks face the choice of whether to allow the crisis to unfold, which would risk taking down major financial institutions, hedge funds, and millions of over-leveraged US home owners, as well as affecting the status of the dollar in unpredictable ways. Or will they try, as I have argued in several articles (The Fed's Box Canyon, Bernankeism, End Game: Hyperinflation) to monetize their way out of it? This week's actions suggest that the latter will be chosen.

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