How Worried Should You Be About Turmoil in the Markets?

Last Updated Aug 20, 2007 4:32 PM EDT

Stocks have slid sharply lower the last two days over liquidity fears prompting the Fed to inject a further $19 billion into the system today. The central bank said it was acting "to facilitate the orderly functioning of financial markets." European and Asian markets were also down and European central banks took similar action.

Is this a full blown disaster of just a needed correction to the overly risky lending of the last several years? And is the Fed doing enough to ease investors' pain?

Before answering these questions, one needs to understand exactly what's going on. Analysis in the NY Times today offers a handy analogy to understand the current feeling towards securities based on questionable lending:

With the worth of those securities now being questioned -- and no equivalent of deposit insurance -- some who financed the securities want their money out, a fact that has created the 21st-century equivalent of a run on a bank.
Of course, the Times notes, "money can be lent to those owning the dubious securities, obviating the need to sell. As they eventually turn out to be good, the loans can be repaid and all will be happy. On the other hand, if many of those securities turn out to be as bad as people now fear, some of those loans will not be good, and there may be more financial failures."

The latter possibility sounds pretty grim to those invested in the problem securities, but as the Guardian's Ashley Seager points out, "The real economy in Britain, Europe, Asia and even the United States are robust and should be able to withstand these market tremors. Financial market woes rarely cause serious economic damage and are unlikely to do so again this time." In Seager's view this is a correction, not a meltdown. Though if you are one of those excessively indebted homeowners upon whom this crisis is based, that could be pretty cold consolation.

So what's Ben Bernanke going to do? The short answer is even the experts can't agree. Expressing their views in the Wall Street Journal's Economics blog, analysts are saying everything from, "the Fed is bound to cut interest rates rapidly and aggressively" (Ed Yardeni, of Yardeni Research) to "there is likely a current strategy to address market dislocation through direct liquidity injections, rather than through immediate reductions for the target rate" (John Shin, Lehman U.S. Economics). Though the final consensus seems to be that odds are better than ever that the Fed will lower interest rates in September.

Whatever action the Fed takes may have little effect, however. The NY Times points out, the "the Fed's influence is limited when lenders are suddenly risk-averse." Kingman Penniman, president of KDP Investment Advisors, explains: "The impetus of lowering interest rates may not help, if they don't let you borrow in the first place."

The nugget of wisdom here is don't panic and start banging on your broker's door like a bank depositor circa 1929. Sit tight, mind the economic fundamentals (don't spend more than you earn, don't borrow more than you can pay back), and see how it all shakes out.

  • Jessica Stillman On Twitter»

    Jessica lives in London where she works as a freelance writer with interests in green business and tech, management, and marketing.