of the problem began with the foolish idea that you can put people in homes who have no income, no wealth, and no regular job history. Then on top of this, the financial community created some very complex financial instruments, whereby the originator of a mortgage could throw the mortgage out into cyberspace and someone would put a guarantee on it.

Today’s housing bubble was financed with excessive and poorly regulated mortgage debt, and as housing prices began to tumble from the peak, the delinquencies and foreclosures have led to a downward spiral of debt liquidation that in turn led to even lower prices and more foreclosures. The spark that ignited a crisis environment was a surge in defaults on sub-prime mortgage loans which financed much of the housing bubble. This spark was amplified by the complex way in which these mortgages were bundled together, the leverage financial institutions employed in acquiring them, and the volatility in financial markets. Many of these mortgages were always going to go bad. However, the complexity of their packaging meant that when they went bad, it would be very difficult to value them. Moreover, investment banks and others compounded the problem by investing in these mortgages using high degrees of leverage. This leverage, which enhanced profits in a rising housing market, also added so much to losses when the loans went bad as to undermine the solvency of some of these firms. The volatility of markets and the web of complex inter-relationships among financial firms were the two ingredients in this recipe for disaster.

The reaction by banks and other financial firms has been drastic. Banks and Wall Street firms, worried about both their own needs for cash and condition of other institutions essentially stopped loaning money to one another. That choked off the money being made available on Main Street in the form of mortgage loans, business loans and other consumer borrowing. Federal Reserve Chairman Ben Bernanke spelled out the implications of this credit crisis by talking of how small businesses would not be able to get the credit they need to operate, grow and hire workers. Consumers would have trouble getting mortgages to buy homes, further driving down prices. And tighter credit would mean lower sales of cars and other big ticket items, leading to more plant closings and layoffs.

The Federal Government’s reaction has been to respond on multiple fronts to shore up the U.S. economy. The federal Reserve has cut interest rates to 1 1/2 percent. Congress passed a $168 billion stimulus package earlier this year. The Treasury and Federal Reserve have engineered multiple Wall Street rescues and put together a plan to buy hundreds of billions of dollars of money-losing assets. This program, called the Emergency Economic Stabilization Act, was passed by Congress on October 3, and it effectively uses the U.S. Treasury’s balance sheet to take on impaired mortgage assets from banks and other financial institutions that can’t find buyers for such instruments–at least not at anything but giveaway prices. In theory, the program would purchase those assets at prices above fire-sale levels, but not so far above that the government, that is, taxpayers, couldn’t profit down the road, even if that road is long and bumpy. The Treasury would fund the program by issuing securities, that, because of the strong demand for government paper, pay less than 2 percent for shorter maturities. At the same time, it could earn double-digit returns on the assets as they are resold. The idea behind the Rescue Program is that sellers of impaired assets would use the cash received from the program to make new loans or investments, thus reliquefying the financial system.

In our opinion, this Program will succeed in its primary assignment of reducing panic and breaking the near-term credit logjam. But it will not instantly end the possibility of more bank failures and bank lending could remain tight for some time. As for the economy, the rescue plan will not come in time to avoid some negative GDP growth but, together with continued easing by other central banks, it will serve to avoid the serious global recession that had been feared by many. Going forward, U.S. investors will still have to adjust to some negative economic growth, falling earnings estimates for the just-ended third quarter and fourth quarter, and the uncertainty of the election and aftermath. With the financial markets around the globe at extremely oversold levels, the overall investment climate looks much more like that found around major buying opportunities and worth selectively adding good-quality, depressed companies with strong balance sheets to portfolios.