The current financial crisis is a crisis of trust. It's said that the banks are hoarding their cash and not lending because they don't know who is really solvent and who isn't. Allow me to suggest a slightly different thought.
The banks are not afraid of everyone else, they're afraid of themselves. Each individual bank is afraid of what it's going to find in its balance sheets because of the subprime mortgage securities and so its hoarding cash until the smoke clears and they have a better idea of what is going on. Today's first auction of such assets will start to clear up the situation.
Once they have a better idea of the value of their assets, they'll know how much they can lend. Until then, no bank wants to get caught with too much money lent out and not enough assets backing it up. In the meantime, the government is acting as the short term lender for the economy.
The Federal Reserve has announced a radical plan to buy massive amounts of short-term debts in a dramatic effort to break through a credit clog that is imperiling the economy.Things will calm down and the market will rebound once the value of these assets is established through real, live auctions.
The Federal Reserve said Tuesday it will buy "commercial paper," a short-term financing mechanism that many companies rely on to finance their day-to-day operations, such as purchasing supplies or making payrolls.
Update: Jim Jubak of MSN Money agrees and has a much better version of the explanation.
Update 2: The auction is done. The results were a little disappointing. Full details are here.
Felix Salmon over at Seeking Alpha gives the most in-depth assessment of the situation that I've seen.
The fact that a market clearing price was found, regardless of disappointment, is what is important. Once the real value of assets can be determined, then the clean up of this mess can start.
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