Clearly, we are at the early stages of a very significant credit crunch that will need to naturally work itself out if we are to emerge on more stable economic footing. Despite the Federal Reserve and the ECB having significant ammunition to help improve liquidity, such measures will be rather superficial in light of how pervasive the problems are. It would be unfortunate if central banks and federal governments extend the current credit bubble because the repercussions would be even greater in the future. Instead, would be better to save the big guns for when things get worse.

There are several reasons why the problems will not be solved by overly accommodative monetary policy. With regard to the U.S. mortgage market, cutting the federal funds rate might help ease the impact of teaser rate loan resets but the cuts themselves (however dramatic) cannot erase the real problem. Many borrowers never expected to hold on to their existing mortgage long enough for any kind of interest rate reset. Most residential mortgages originated in 2005 and 2006 should never have been made and a Fed bailout would only encourage that type of reckless behavior. Another reason the central bank should exercise caution is that the yen carry trade seems to be on particularly unstable footing. When that begins to unwind, as it appears to be, then lowering of short-term interest rates and increasing the money supply in the U.S. and Europe will only provide fuel to the fire and exacerbate the adjustment. The central bank is often relied upon to avert all financial disasters. That over reliance can sometimes pressure it to do things that will only make the situation worse.

The credit issues are spreading. Although the first signs of credit problems were seen in the U.S. residential mortgage market, a significant number of hedge funds located across the globe have imploded. Investors are reading the headlines and wondering who is next. Hedge funds that are not wholly invested in highly liquid assets (a definition that changes daily) are finding themselves in a very bad predicament as loans are called and redemptions flood in. If we see an increasing number of funds halting redemptions, as I expect, confidence in the market will take another severe blow. Many banks claim to have diverted risk by packaging and selling off their loans to other third parties but often the groups they sell the loans to are some of their best customers. The lack of transparency is not helping to ease investor fears. It is a tangled web and very few are immune to the problem.

Most of private equity is entering a deep slumber, which it desperately needed. Many titans of Wall Street will have to accept human status at least for a while. However, as with any great economic shift, some people and companies have shown a keen perception having positioned themselves extremely well in the current market. One such star is the Hedge Fund, Paulson & Co. In 2003 it had a respectable 700 million under management. However, this year alone, assets under management at Paulson & Co. doubled from $10 billion to $20 billion due in large part to investments that benefited from the collapse of the sub-prime mortgage market.

Its time to be defensive if one has not done so already. There are some great opportunities amidst this change and even greater opportunities to follow. It is either a very exciting or frightening time depending on your perspective. As always, I will be keeping a very close eye on the markets and look forward to giving future updates as events warrant.