These are interesting times to write an economic update, as we continue to face a financial crisis. I remain confident we will not have an actual collapse – beyond what we experienced from September-November. To the contrary, the actions the Government is preparing to take should get the credit markets and banks functioning again in the next few months. However, our economy is further damaged every day they aren’t. A dysfunctional or frozen credit market has large, negative ripple effects throughout the economy. If you study every financial crisis in the world over the last century, you will find that nearly all of them were associated with frozen credit markets and bank failures. This is serious business.

Given these facts, this update will focus on the status of the banking system and mortgage market. If we know how they are going to turn out, we will have a pretty good idea as to what will transpire in economy. In fact, you cannot begin to know what will happen without that knowledge. (As we will see, even with this knowledge we cannot predict the short-term movements of the stock market.)

An excellent description of what is going on with our financial institutions and mortgage markets was published in the Wall Street Journal on January 17, entitled “U.S. Plots New Phase in Banking Bailout.” The summary of this article is that our banks are still in trouble, including some of our largest banks. We are most likely through only half of all the losses investors and financial institutions will suffer before the mortgage-backed debacle is cleared up. This means financial institutions are likely to lose up to $1 trillion more than they have already. The article quotes Martin Feldstein, a Harvard economist who “has consulted with the new Democratic majority on Capitol Hill and is the former head of the Council of Economic Advisors under President Ronald Reagan”: You can’t solve the overall economic problem if you can’t get the financial institutions lending again. And you can’t do that as long as they don’t know what the value (of their troubled assets) is, particularly the residential mortgage-backed securities and derivatives based on them. That describes our current situation very well. And if something is not done about this, our major financial institutions will go under.

Fortunately, a lot is being done. The article goes on to explain the approaches being taken and considered to fix this serious problem. The essential idea is that the Government must get the troubled assets, mostly mortgages, off the books of the banks. This was the original idea Treasury Secretary Paulson proposed last year when the TARP (Troubled Asset Relief Program) was enacted by Congress, in which Treasury planned to buy the troubled mortgages from the banks. Unfortunately, Mr. Paulson later correctly realized that this would take too long to enact (and his proposal seemed very bad for taxpayers), and in October we had to stop our financial system from collapsing immediately. The Treasury Department therefore decided to make direct investments into the banks, purchasing “preferred stock” in them in order to keep them afloat. But the “toxic assets,” all our questionable mortgages and the derivatives on them, did not thereby disappear. In fact, as the economy weakens the problems just get worse, and are guaranteed to continue to do so unless this is fixed. As the economy weakens further, more people lose their jobs and stop paying their mortgages, leading to more foreclosures and bank losses, etc., etc.

There are two ways to get these mortgages off the books of our banks. 1) The approach the Treasury Department has been taking the last six weeks is to insure Citigroup and Bank of America against further losses on these mortgages. In each case, Treasury invested billions more in each bank and simultaneously insured these banks against losses in their troubled mortgages and related derivatives on them. However, as the article discusses, this may not work. We want our largest financial institutions to lend money. In order to do so, they have to have large institutional investors, and millions of smaller ones, lend or deposit hundreds of billions of dollars with them. That’s how money gets spread throughout our economy. But large institutional investors may not be willing to invest in or lend to banks if they still have any connection to the bad mortgages – even if the Government is insuring them against losses. (In addition, once again I do not think this approach is best for taxpayers. I can see why Citigroup and Bank of America thought it was a great deal. They get insurance – in Citigroup’s case $300 billion worth – against their huge risks at no charge. The taxpayers then get all the liability, but no chance of any profits.