The Dow Jones Industrial Average was up 290 points on Friday just before the US House of Representatives finally passed, and the President signed into law, the Treasury’s $700 billion bailout.  But the Dow closed down 157 points anyway.  It has fallen another 500 at the time of this writing, and the Dow is now down 1,300 points (or 12%) from its peak just prior to the failed Congressional vote.

Supporters of the bill, along with almost every pundit, argued the bill was absolutely necesary to stabilize the markets.  But the markets are not cooperating.  In fact, volatility and fear are spiking.  One reason is that any Treasury purchases under the plan will not be made for at least two weeks, maybe more.  Another reason is that missteps by the Federal Government have turned what was a large financial problem into a massive one.

Looking back to last year, it is clear the Fed’s rapid interest rate cuts were a huge mistake.  It was clear that risks to lenders were rising as the economy suffered, but because the Fed drove down short-term interest rates, lenders were forced to take less in income.  This undermined lending markets.  Why would a bank make a loan in a riskier environment at a lower interest rate?  As a result, credit spreads widened.  But, for some markets, like those for auction rate securities, the market just froze.  Investors balked at buying these assets at lower rates.  Worse still, the Fed’s easy money caused a surge in commodity prices and a doubling in the price of oil.

Another mistake made by government was not changing mark-to-market accounting rules.  This has turned a containable $300 billion subprime loan problem into a crisis that has become almost triple that size.  Mark-to-market accounting has scared away investors and caused bankruptcies even for firms who are still solvent on a cash flow basis.  These failures have led to more fear and some bank runs. 

These mistakes were like throwing gasoline on a fire.  Now, instead of realizing its mistakes, the government is intervening again with a huge $700 billion intervention in the markets.  The whole purpose of this plan is to stabilize markets, saying people’s retirement savings, businesses, jobs, and homes were at risk.  This helped stir the panic.

~ From First Trust Advisors

Related and Recommended Reading:

Here is a nice collection of quotes from key Washington officials in last week’s Wall Street Journal that sheds light on how we wound up with the Freddie/Fannie debacle.  As Ronald Reagan said, Washington is the problem, not the solution.   

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