Credit Meltdown

The last week of trading has been dominated by an unwinding of positions on a global basis. The culprit; financial institutions and hedge funds that owned exotic re-packaged mortgages (Collateralized Mortgage Obligations, or Collateralized Debt Obligations) ended up facing an illiquidity crisis. They needed to sell in the short term, and it turns out that the crisis of confidence in the financials created an environment in which the pricing of these different CMO's or CDO's became increasingly difficult, thus illiquid. During illiquidity events, the hedge funds, mutual funds, and institutions sell whatever they can to create liquidity. Now, there is an expectation that the Fed will ease rates. However, they already have lowered rates by injecting nearly $45 billion in liquidity over the last week, equal to at least a 1/4 % rate cut.

In the financial markets, firms and individuals that made bad credit decisions must be allowed to pay the price for those decisions. Borrowers that took on too much debt, or lenders who lent too much debt, must learn that there are consequences for their actions. After all, the borrower likely experienced an increase in value, and the lender likely experienced an increase in earnings by behaving this way. Home builders that overpaid for land need to face the music. Wall Street firms that provided credit like drunken sailors must now pay the price. Homebuilders, mortgage companies, and banks have enjoyed exorbitant profits in recent years, as have shareholders and executives of these companies. Why now must the Fed give them all a pass? Nobody wants any company, or industry, to fail, and the Fed will obviously act as it sees fit to contain any contagion. However, to not permit losses now, a la a Fed bailout, is a direct violation of the principles of a free market that are the cornerstone of our economy.