Bailout or No Bailout: It's the Economy, Stupid

So here we continue with the saga of our nation's debt. And that debt is about to become significantly worse. In the meantime, we question if Congress will allow the Feds (via its use of our nation's treasury) to take full reign over attempts to ease the credit liquidity crunch. The Feds have made their case. They are about to demonstrate how the absorption of a handful of frozen and illiquid assets (onto the books of the Treasury) can transform itself into the catalyst for a chocked up credit market.

There are certain elements of the bailout that will undoubtedly have a positive impact on the credit markets. Just as the massive Fannie (FNM) and Freddie (FRE) absorption stabilized the mortgage securitization business, this bailout of all bailouts will allow banks (give or take a few acquisitions along the way) to once again sell their own paper as (their) risk spreads flatten. Fair enough. In the context of lending one could consider it essential to capital expansion.

But that would still leave anyone hard-pressed to defend the bailout and to explain how these massive balance sheet absorptions can positively contribute to the prospects of strengthening credit quality or strengthening an economy. Maybe one could think that reviving the frozen credit markets, will lead to a return of normalized creditworth. After all, many of the banks (and their paper) did see better days. But so did credit risk. And so did our economy.

To think of a shrinking economy in the context of our government's previous policies might appear counter intuitive. Consider that those were intended to fight off the credit crunch by facilitating expansion and economic growth via the process of capital infusion. After all, there was the long string of interest rate cuts, then an economic stimulus package, and of course, the opening of the discount window. Unfortunately, none of these measures were successful in providing a definitive relief to a debilitating credit squeeze, nor did they provide significant economic growth. Quite the contrary, the many financial institutions in this country were faced with an increasingly deteriorating lending environment just as the economy continued its slowdown.

It's not the banks. It's the economy, stupid. After all, this is an election year. And things do get distorted during election years. Even for equity markets which side with the Feds. Well, let's just say, they had no choice. The ban on short selling dictated to the markets that the Feds are catching up to their own abilities to control price action. And maybe that is enough to push back the naysayers. 

So here we are, listening to the advocates of an old and ailing lending system making their case. Some of it is convincing. Some is not. But regardless, there is a sense at least that some of the old practices are brought into question. I am not sure how much ammo Paulson put in his bazooka at Monday's hearings, but I am pretty sure that he must have asked the same question that the shorts did when they woke up to the markets on September 19: "Where did it all go?"

Disclosure: Short Financials.