Will They Avert Catastrophe?

President Bush scrambled to revive troubled bailout talks this morning, stating that "if money isn't loosened up, this sucker could go down."

The problem right now is that this president has cried wolf so many times before that he has lost all credibility.

What is surprising is how the stock market is holding up despite increasing doubts about the bailout:

Policymakers are rightfully focused on the credit markets. If banks are unwilling to lend to each other -- as surging LIBOR rates suggest -- they sure aren't going to lend to consumers or businesses, which has profound implications for the economy (which grew slower in the second quarter than originally reported, by the way.)

• In the short term, companies like Goodyear Tire can't access their cash because of stress in the money market and overnight lending operations. Most businesses need this capital to fund day-to-day operations.
• In the longer- to intermediate-term, a slowing economy means more earnings disappointments such as delivered in recent days by GE and Research In Motion.

Thus far, the stock market has held up remarkably well given those threats. Barring some resolution on the bailout in Washington, stocks won't be able to ignore strains in the credit markets much longer.

"It is unclear at this time whether this intense stress in credit markets is the result of Washington not moving fast enough, or moving ahead with the wrong approach, or simply the result of a cascade of forced balance sheet liquidation," writes Michael Darda, chief economist of MKM Partners. "In any event, these stresses suggest equities could come under considerable pressure in the near term."

And just how bad is the credit in the United States? It's very bad and it is even affecting banks outside the United States.

A senior Canadian banker called me this morning to tell me that Libor rates are not adjusting quickly enough to reflect the depth of the unfolding liquidity crisis. "The cost of funding for Canadian banks and other around the world is a lot higher than normal. This could degenerate quickly as banks stop lending money and keep hoarding cash."

He went on to tell me that the U.S. dollar benchmarks for pricing instruments are "in disarray." Moreover, he admitted that thousands of banks in the United States are teetering on collapse. "It doesn't take much to have a run on banks. If payrolls in the U.S. do not clear because banks do not free up cash, then you will see a classic run on banks."

He also correctly pointed out the following: "Why do people think we are smarter than they were in the 1930s? I do not see any evidence of this wisdom."

Scary thoughts coming from a banker who is pretty conservative in his views.

The evidence certainly supports his views as U.S. credit enters a lockdown:

In many corporate offices, in company cafeterias and around dining room tables, however, the reality of tight credit already is limiting daily economic activity.

"Loans are basically frozen due to the credit crisis," said Vicki Sanger, who is now leaning on personal credit cards bearing double-digit interest rates to finance the building of roads and sidewalks for her residential real estate development in Fruita, Colorado. "The banks just are not lending."

With the economy already suffering the strains of plunging housing prices, growing joblessness and the new-found austerity of debt-saturated consumers, many experts fear the fraying of the financial system could pin the nation in distress for years.

Without a mechanism to shed the bad loans on their books, financial institutions may continue to hoard their dollars and starve the economy of capital. Americans would be deprived of financing to buy houses, send children to college and start businesses. That would slow economic activity further, souring more loans, and making banks tighter still. In short, a downward spiral.

Fear of this outcome has become self-fulfilling, prompting a stampede toward safer investments. Investors continued to pile into Treasury bills on Thursday despite rates of interest near zero, making less capital available for businesses and consumers. Stock markets rallied exuberantly for much of Thursday as a bailout deal appeared in hand. Then the deal stalled, leaving the markets vulnerable to a pullback.

"Without trust and confidence, business can't go on, and we can easily fall into a deeper recession and eventually a depression," said Andrew Lo, a finance professor at MIT's Sloan School of Management. "It would be disastrous to have no plan."

...

Suddenly, people who have spent their careers arguing that government is in the way of progress — that its role must be pared to allow market forces to flourish — are calling for the biggest government bailout in American history.

"We are in a very serious place," said William Beach, an economist at the conservative Heritage Foundation in Washington. "There is risk of contagion to the entire economy."

The risk of contagion is quickly spreading outside the United States as Libor rates soar worldwide:

The three-month London interbank offered rate, or Libor, that banks charge each other for dollar loans jumped today by the most since 1999 and the euro rate rose to the highest level since November 2000. Rates in Hong Kong and Singapore climbed as Bank of East Asia faced a run Wednesday on deposits. The difference between the three-month dollar rate and the overnight indexed swap rate, the Libor-OIS spread, widened to the most on record.

"Liquidity in the money markets in maturities over a week is desperately scarce," said Tim Bond, head of global asset allocation at Barclays Capital in London. "A near-term solution to the crisis is urgent. Unchecked, the current crisis would turn into a self-reinforcing vortex of defaults, bank capital contraction and deep recession within a matter of weeks."

Money-market rates signal banks have all but stopped lending to each other. Treasury Secretary Henry Paulson's bailout plan, which proposes removing tainted assets from bank balance sheets, may be cut back in size, U.S. House Budget Committee Chairman John Spratt said Thursday. The U.S. faces a "painful" recession if the package isn't approved, President George W. Bush said Wednesday.

"The message coming from our money-market traders is that nothing's working," said Padhraic Garvey, the Amsterdam-based head of investment-grade debt strategy at ING Bank. "Banks are not dealing with one another and the situation has gotten worse. The real market is probably about 10 to 20 basis points above where Libor fixings are."

I am hopeful that politicians will come up with something to avert catastrophe, but I remain bearish on stocks and the U.S. economy.

What people need to realize is that the structural problems underlying this financial crisis are so perverse, so widespread and regrettably until recently, so underestimated that there is no way we are going to get out of this mess quickly.

It will take years to clean this mess up and restore confidence in the global financial system.

My only concern right now is that U.S. politicians are skirting with catastrophe here and they better come up with something fast to calm credit markets or else we will all pay a heavy price for their posturing.