The equity markets experienced angst and volatility in the quarter, but stocks were not the real financial thriller.  The markets focused instead on the complete freeze in fixed income securities backed by real estate loans.

The tremors in the credit markets actually began in a rarely newsworthy area called asset-backed commercial paper.  The day-to-day borrowing needs of many corporations depend on the functioning of the commercial paper market, some of which is backed by securities invested in mortgages.  When the credit quality of these mortgages declined and institutions were not certain how much they were worth, the market froze.  Financial institutions were afraid to trade and lend to each other.  The scare in the markets incited some bank depositors in the US and London to actually line up to withdraw their savings.

As a result of this uncertainty, the central banks at home and in Europe were forced to take emergency measures to inject funds into the banking system.  Highly leveraged participants in the credit markets, such as hedge funds, suffered huge losses as the value of their asset-backed mortgage securities sank.  Many of these trading institutions needed to raise cash to cover these losses, so they sold equities; the equity markets, in turn, felt the aftershocks of the credit market quake during the quarter.

                 
Our central bank’s first move was to cut the discount rate to accommodate institutions that needed short-term financing.  With investors still on edge, the Federal Reserve then announced a cut in the federal funds rate by ½ of 1 percent on August 18 – more than most investors expected.  The cut in the federal funds rate quieted the credit markets and lifted the stock market.  It was a classic rescue effort.  By the end of the quarter, stock markets were up, and prices on weak credits improved.

As companies now report earnings for the quarter, it is no surprise that many of the financial institutions are reporting large losses as a result of the credit freeze.  More losses are sure to follow.  The housing market which underpins the problem has only gotten worse, and a long workout is likely to persist.  Homeowners will need to reduce the prices on properties for sale; mortgage borrowers could face higher mortgage payments; and mortgage originators are already reducing staffs or closing.  As painful as these adjustments are and although it may take some time to correct, the housing market will improve once the excess supply of homes is reduced and borrowers manage to refinance.  Whether or not it will have a lasting effect on the economy, we discuss below.