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The Credit problem – What is it?

I’m sure that you’re drowning in the much bandied about term – Credit crisis or Credit crunch or liquidity crisis or the like. And I’ve come across some explanations of what event or series of events underlie this crisis. For a very good explanation of the problem and the failed bailout by the current Treasury Secretary Paulson, I refer you to this site – Understanding Tax.

As I pointed out in the previous post – Are you ready for the Supply Chain Shock?, a credit crisis is not a laughing matter and a serious credit crisis will send numerous shocks through the numerous supply chains of the world. The author of the article also points that out,

You might think of short-term money as the lubricant that keeps the world’s economic engine turning over smoothly. If there’s no lubricant,the engine freezes. No paydays, no goods on the shelves. Seriously.

So what is the purpose of the bailout bill? Let’s be clear about the probable scope of the current crisis – it’s not going away tomorrow if the bill is somehow passed in the House.

Note that Mr. Paulson’s proposal was not intended to solve the teaser-rate mortgage problem, either now or in the future. In the transactions that created the teaser-rate mortgages in the first place,both parties made bad decisions – the lender and the borrower. Mr.Paulson’s proposal was not intended to help either. One of its unavoidable side effects, however, was to relieve lenders of the consequences of their bad decisions, while leaving borrowers to suffer the consequences of theirs. This made it politically less palatable.
In addition, at least $500 billion more of teaser-rate mortgages are scheduled to reset over the next several years. In all likelihood, they too will go into default and become toxic waste. Nothing in Mr.Paulson’s original proposal was intended to do anything about this next$500 billion installment – or, indeed, to prevent lenders from making more teaser-rate mortgages in the future.
Similarly, Mr. Paulson’s proposal was not intended as a general Wall Street bail- out, although to some extent it would have had that effect.Note that the outstanding overhang of credit default swaps alone is estimated to be between $45 and $60 trillion – three to four times the size of our annual gross domestic product. The requested $700 billion, although the single biggest appropriation request in U.S.history, was miniscule when compared with the toxic waste problem as a whole. Mr. Paulson’s proposed solution was to cost just 1% of the size of the problem and was aimed only at a small part of that problem. (It is unnerving to realize that the U.S. government – the

Category: Personal Observations, Strategy, Supply Chain Management

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One Response

  1. JP Farrell says:

    Excellent and timely post.

    Today it seems more likely that the revised plan, HR1424, summarized in this letter from Dr. Peter Orszag, Director of the Congressional Budget Office to Sen. Chris Dodd, Chairman of the Finance Committee (http://management-consultant-at-large.googlegroups.com/web/hr1424Dodd.pdf?gda=PWOcikAAAAB1iikhPwrMaGtUQl2cT77vPXVEsKam0wN6cwFy2ZPqug7GdXbR4XadjXE3rLkRe5ptxVPdW1gYotyj7-X7wDON) will pass. As the details and intent of the Emergency Economic Stabilization Act of 2008 become more clear, we are learning more about the extent of this crisis. Breathtaking as the $700 billion number appears, it is small relative to the total amount of junk afloat in the global waters of the system. Credit default swaps alone are estimated to be in excess of $60 trillion (pause, take deep breath, and read that again).

    Rather, according to Orszag, “The Treasury proposal appears to be motivated primarily by concerns about illiquid markets.” That makes sense. A lame duck Congress and a lame duck Administration would have no chance of passing a bill of this magnitude were it not a stopgap measure aimed at alleviating an impending crisis.

    Let’s watch the movement in letters of credit over the next week to see if there will be any goods at all on retail shelves this holiday season. It would not be a good time to be selling airfreight capacity.

    I’ve been following this crisis closely on my own blog, “A Management Consultant @ Large” at http://jpfarrell.blogspot.com.

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