Thursday, November 6, 2008

Restoring Confidence..or Not

Financial markets, and particularly credit markets, rest on a foundation of confidence, the first principle. When banks lend to each other, when strong industrial companies float commercial paper, there is a confident belief that the lenders will be paid back on a timely basis. This belief is fostered by due diligence and analysis of the credit, for sure. However, it really rests on experience, a history of transactions, and on a belief that a market player will play by the rules.

So, in traditionally deep and liquid markets, like the interbank markets and commercial paper, the risk premia applied to the cost-of-funds rate are usually thin. Now, despite all the Treasury and Fed's opening of the checkbook, the markets still remain frozen, albeit with a thin layer of melted water on top.

The confidence to make credit markets work has not been restored. Massive amounts of liquidity have been injected, but the liquidity has become trapped, to borrow a usage from John Maynard Keynes.

Jim Grant's observation is on point: "The bear market is truly a value restoration project. Wall Street will be going on sale--if the government will let it." We need to get on with the "creative destruction" process. First the cleansing, then the renewal. Forty government folks sitting in a building deciding who is going to survive and who will not is no way to get us out of this fundamental crisis. The Federal Government needs to stand down and let the markets work. There are certainly some legal, administrative and regulatory adjustments that need to be made to facilitate this process. But, no more, "Ready, fire, aim."

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