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Revisiting the Credit Crisis

Banks failures kept climbing and the Asset Back Security market completely froze up. While it sounds like a grim description of the height of the Credit Crisis, it was actually the week of July 19th.

In little reported news, there was no issuance of asset backed securities (ABS) last week. Large companies rely on this type of financing to fund their short term needs. The collapse of this market in the fall of 2008 was one of the key reasons that economic activity ground to a halt. Recently, everything looked OK for the ABS market. During the ten weeks prior to July 19th average issuance was $1.83 billion per week. Then suddenly it was zero.

The overnight disappearance of funding was an unintended consequence of the new financial 'reform' bill. One of the provisions of the bill made the rating agencies liable for their ratings - a laudable idea. However, there was no provision on the other side that prevented them from taking money for their ratings and then refusing to have them made public, which the rating agencies promptly did in the ABS market. Companies were already required by law to have their ABS paper rated before financial reform - essentially giving the ratings agencies a government enforced duopoly. So without ratings nothing could be sent to market. Even Ford Motor ( F ) had to pull a major offering. To unfreeze the market, the SEC promptly ruled that ABS paper could be sold without a rating for the next six months. This too could have unintended consequences.

The Credit Crisis was also being revisited with a U.S. banking system that still looks shaky. So far this year, 103 U.S. banks (NYSEArca: KBE) have failed compared to 65 at the same time last year. At the current rate, failures could exceed 200 in 2010. This is roughly on par on a percentage basis with the worse period of the Savings and Loan Crisis. However, the FDIC, which insures bank deposits, didn't go under during the Savings and Loan Crisis. This will happen this time. There are even rumors that the FDIC is delaying taking over insolvent banks to delay its own insolvency. These rumors are probably not true because doing so wouldn't buy the FDIC that much time. Expect the federal government to bail it out with a 'loan' or some other 'line of credit'.

The problems that surfaced during the Credit Crisis have obviously not all been solved. Investors should assume that the after effects will have to be dealt with for years to come. Government solutions for dealing with these problems may themselves in turn cause other problems. The corruption in the system certainly hasn't gone away. The ratings agencies gave baskets of subprime loans triple A ratings and now they have refused to let their ratings be used for asset backed securities because of potential liability. So how accurate do think their ratings are now? And why does the U.S. government force companies to pay them for the ratings if companies aren't guaranteed anything in return for their money? If this type of activity took place between two businesses, it would be called an extortion racket. The FDIC forcing banks to prepay three years of deposit insurance premiums could be viewed the same way.

Disclosure: No positions.

Daryl Montgomery

Organizer, New York Investing meetup

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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