The public attention is still on the default of subprime mortgage loans. There the defaults are further increasing:

One in every five adjustable-rate subprime loans had late payments in the quarter, a number that excludes the one of every 10 already in foreclosure, the trade group said. Foreclosures started on all types of mortgages rose to an all-time high of 0.78 percent from 0.65 percent.

When you can get Two Houses for the Price of One something is indeed very wrong.

The parameters of the mortgage rescue operation by the "broad coalition", i.e. Wall Street, have been released.
The idea is to forestall interest increases on some Adjustable Rate
Mortgages for some time. The announced plan is quite restrictive, legally flawed
and will likely be ineffective:

Barclays Capital — extrapolating from a similar program
recently unveiled in California — estimates that only about 12 percent
of all subprime borrowers, or 240,000 homeowners, would get relief.

The Citigroup bailout via a ‘Super Fund’ for Structured Investment Vehicles is, like I expected, going nowhere.
The size of the plan has been halfed to $50 billion and, as predicted, the three involved banks have found no one else who will take
part in this looser scheme.

The credit problems are widening. The banks securitized all kind of loans and sold them off as Collateral Debt Obligations. Mortgages defaults are up. Now auto loan defaults are increasing. In the next step securitized credit card loans will follow. People who can not pay their mortgage also can not pay for their car or balance their credit cards. Student loans are another problem. When the economy slows down, defaulting commercial loans will add to the shitpile of bad debt.

The inappropriate lose credit standards, induced by much too low central bank rates in 2001-2006, were extended to all types of credits. The inevitably higher default rates of such lose credits were inexcusably not anticipated by the rating agencies and CDO investors.

Here is a nice flash animation explaining the CDO mechanisms. Mortgages and other loans were bundled, chunked up and classified by estimated default rates. These CDOs were sold off to various investors. Credit repayments first gush into the ‘top bucket’ of AAA rated CDOs. The overflow fills the lower buckets of Aa rated CDO’s and so on. If the mortgage payments slow to a trickle, the lower buckets will stay empty and their value trend to zero. That normally wouldn’t be a problem, but when many mortgages default, even the Aa buckets or even the top class AAA buckets will have losses. This is where we are right now.

The situation was certainly not unforeseen. This interesting NYT piece explains how many big banks, especially Paulson’s Goldman Sachs,
insured or sold their own holdings of risky CDO papers while marketing
the same junk to pension funds and other dumb investors. Now these investors and their clients are in trouble.

With defaults and dubious investment holdings all around, the economy is in deep trouble. To prevent or at least cushion the economic downturn Roubini called for the central banks to lower interest rates. All of them, except the European Central Bank, seem to follow that advice.

I regard this as pushing on a string with bad side effects. Let me explain.

In normal times the central bank sets an interest rate which is the price big international banks pay to borrow from the central bank. The big banks add a bit to the interest rate they have to pay and then loan the money to other banks. From there the new creditlines are given to manufactures etc. who can use the money in their operations and hopefully make a return above the rate they have to pay. (This is simplified, but the principal holds.)

The lower the central bank sets the rate, the more likely manufacturers will use the cheaper money to invest and make a profit on these new investments. A rate decrease induces an increase in economic activities.

When the economy runs too hot and prices go up because all capacities are in full use, the central bank will increase its interest rate to cool the economic activities and to stop the inflationary tendencies.

It takes somewhat between 12 to 18 month until a rate change is measurable as a change in economic output.

But the model has two problems.

If the cheap money the FED is pushing into the economy is invested in non productive issues, asset bubbles occure. This was the case between 1995 and 2000 in the tech stock market and later in housing and consumption. The manufacturing investment did happen too – not in the U.S. but in China. The classic central bank theories stop at the boarder and are thereby somewhat flawed.

The second problem in the central bank model is the assumption that the lending between banks pushing the cheap money into the markets is reliable and occurs with only a modest addition to the central interest rates.

The London Inter Bank Offered Rate is the rate one bank will charge the other for an unsecured loan. Usually the LIBOR is a constant bit higher than the central bank rate. But with the defaulting CDOs and lack of knowledge about who owns such junk, banks have stopped to trust each other.

Who knows how creditworthy the counterpart really is when there is so much bad debt around?

Bank A now demands a high risk premium for any loan it may give to bank B. The difference between the central bank rate and LIBOR is therefore now much higher than usual. It is no longer driven by the central bank rate, but only by fear of a possible counterpart default.

The normal FED easing mechanism is broken. Even if the central banks lower rates the interbank rates will not decrease.

This will only be fixed when banks start to trust each other again. As long as banks and other entities do not fess up about their debt and their losses on CDO holdings, the trust will not come back.

Any lowering of the FED rate will not fire up the economy but the big banks will take the money and put it into vaults or invest it into secure assets, most likely commodities, and thereby increase general inflation. The resulting economic state is known as Stagflation.

So my reasoning is different than Roubini’s. He seems to believe the system still works: lowering of the central bank rate will help to cushion the recession and induce new economic activity. He disregards any clear possibility of higher inflation.

Like Jim Rogers I believe that any lowering of the central bank rates will push money not into the productive economy, but into some unproductive assets class, likely commodities, and induce another bubble there. The summary effect is increasing inflation in a recessive or stagnating economy.

Only renewed trust between all economic entities, banks, manufacturers and consumers can repair the system. To regain this trust, the bad entities have to be shaken out. A real recession will do this. Any attempt to cushion it, by some half assed rescue schemes for faulty mortgages and bad investments, or by near zero-interest central bank money, will likely prolong the pain while at the same time inducing very unhealthy side effects, i.e. inflation.