All eyes are back on Washington following the US House of Representatives’ failure to pass a financial rescue package Monday. Optimism about elected officials’ ability to respond efficiently and effectively seems to have buoyed investor sentiment, as Asian markets recovered from early swoons overnight and US indexes posted triple-digit gains off Tuesday’s open.

Equity markets--particularly in the US--are important these days because of the psychological impact of 7 percent daily losses on 401(K) investors. That pain will soon overcome the short-sighted, “populist” reaction against what has been poorly described as a “Wall Street bailout.”

Reconsideration and passage of the rejected bill or introduction and acceptance of a politically viable alternative by the US House of Representatives could get all-important short-term funding markets clicking again. Early indications today are that interbank lending may have loosened, if only slightly.

Let’s work with what we know, however; the recent performance leaves little room for confidence in the cast of what’s rapidly devolving into The Tragicomedy Formerly Known as The Washington Consensus.

If we venture one assumption, and this is actually based on the record, it’s that the Fed, the Treasury and the Federal Deposit Insurance Corp (FDIC) have substantial tools to fashion a series of alternative solutions. That’s what we’ve experienced up to now: an institution-by-institution, case-by-case approach.

The Fed will continue to boost liquidity and could cut rates if we see more of what went down Monday. A big, red “777” on TV screens is scary; what’s truly frightening is the slowdown in economic activity those digits portend.

One quick, dirty look at the here and now is the interbank lending market. The TED spread--the difference between the three-month Treasury bill and the three-month LIBOR--is an indicator of credit risk; US T-bills are considered risk free, while the LIBOR reflects the risk of lending to commercial banks. As the TED spread increases, the risk of default--counterparty risk--is seen to be rising. As it decreases, risk is receding.

As you can see below, we’ve charted new territory, though the spread has narrowed a bit.


Source: Bloomberg

Banks, crippled by their own books of impaired assets, won’t lend if the perceived risk of default is increasing. And as banks write down those impaired assets, they have less cash on hand to loan. That’s an enormous problem for our credit-driven economy. The financial system’s gears--the mechanisms that carry funding from central banks to banks to customers for home and car purchases, to pay tuition, to build businesses--are jammed.

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Many commentators have noted that the TED spread can remain elevated for an extended period without the world coming to an end because global central banks, led by the Fed, have flooded the system with so much overnight liquidity that banks can get as much cash as they need. LIBOR is an indicative rate: it’s the rate at which banks would lend to each other--if they were lending.

We’re dealing with a perfect storm: fear, lack of trust and ideological ambition. But Federal Reserve Chairman Ben Bernanke, Treasury Secretary Henry Paulson and FDIC Chairwoman Sheila Bair will keep bailing and rowing, bailing and rowing to keep the system afloat.

The Fed announced Monday it would triple the size of a special program through which it injects cash into banks and also vastly expanded a lending program for foreign central banks to make USD620 billion available to pump into the financial systems in other large countries.

The Fed could continue to use Depression-era legal authority to lend to any “individual, partnership, or corporation” in “unusual and exigent circumstances,” as it did with Bear Stearns and American International Group (NYSE: AIG), to take on troubled mortgage securities weighing down bank lending.

But the Fed’s resources are limited. As of last Wednesday, the Fed had USD1.2 trillion in assets on its balance sheet, but USD150 billion of that was extended in special loans to banks, USD262 billion was in various emergency lending facilities (including to the investment banks and to AIG), and USD29 billion was tied up on Bear Stearns assets that the Fed holds.

The Fed has to keep a certain amount of assets on hand for its day-to-day task of managing the money supply; that and the measures announced yesterday leave it with a dwindling capacity for big interventions in the financial markets. The next step is to fire up the printing press.

The FDIC agreed to share the risk on a USD312 billion portfolio of loans to get Citigroup (NYSE: C) to pull Wachovia (NYSE: WB) out from under. The FDIC invoked its nearly unlimited power to save depository banks it deems fundamentally important to the financial system to make sure Wachovia would be sold. The FDIC promised to cover any losses for Citigroup, above USD4 billion a year for the next three years.

The case-by-case method could end up costing more than USD700 billion. And taxpayers will eventually bear the costs, whether Congress acts or not. More taxpayer money implies that the US will issue more debt. A huge new supply of Treasuries will be dollar negative.

Futures on the Chicago Board of Trade show a rising expectation the Fed’s next move will be to lower the fed funds rate, its target for overnight lending between banks. Lower interest rates may also weigh on the dollar.

A piecemeal approach or a systemic rescue may restore investor confidence to battered financial markets, but the focus will eventually fall on the twin US budget and current-account deficits and negative real US interest rates. The dollar is headed for tougher times.

Finally, a Bailout Plan for Investors

Top Wall Street executives left holding millions, but many small investors got left holding the bag.

Now, however, there is a project underway that will bail out investors.  It's the biggest rebuilding effort ever undertaken, and it will reward early responders with millions of dollars for the rest of their lives.

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Canada is already suffering the effects of what’s sure to be a serious US recession. But what may be bad for the dollar is good for physical commodities. The medium-term picture is better for resource-intensive countries with sound domestic financial fundamentals. The long-term picture is all about a global shift in economic growth leadership to countries with rapidly emerging middle/consumer classes.

The US Congress can’t cure all that ails the economy. It can, however, restore some sense that Washington can respond in a useful manner, one befitting its (inevitably dwindling) status as the world’s sole superpower.

Speaking Engagements

Fall is the perfect time to enjoy Washington, DC’s outdoor treasures and catch a glimpse of nature’s splendor. And this year you can enjoy the immediate aftermath of the Presidential election in the seat of the federal government.

Join me and my colleagues Neil George and Elliott Gue for the DC Money Show, Nov. 6-8, 2008, at The Wardman Park Marriott.

Go to www.moneyshow.com or call 800-970-4355 and refer to priority code 011362 to register as our guest.

We also have a special invitation for our readers. KCI Communications, Inc., is organizing an exciting 11-day investment cruise Dec. 1-12 through the Caribbean and Panama Canal. Participants will have the opportunity to meet and chat with my colleagues Gregg Early, Neil George and Elliott Gue.

This will be a unique opportunity to step away from your daily routines, relax in one of the most beautiful parts of the world and share analysts’ knowledge and passion for the markets. During the sail, you’ll not only explore the cerulean splendor of the Caribbean, but you’ll also delve deep into current markets in search of the most profitable opportunities for your portfolios. You’ll also have the rare chance to sail through one of the world’s engineering marvels, the Panama Canal.

It’s always a special treat to meet and talk with subscribers in person, and we couldn’t have picked a better setting than aboard the six-star Crystal Serenity. This is sure to be an especially memorable experience. We hope you’ll join us.

For more information, please click here or call 877-238-1270.