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A Wide Decline Has Been Set in Motion

The credit crisis is growing, and further intervention by the Fed would offer only temporary relief.
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This blog post originally appeared on RealMoney Silver on Aug. 16 at 8:06 a.m. EDT.

Over the past two years, I have consistently warned against the broad implications of the egregious use of leverage (in financial institutions, at hedge funds and at the consumer level), the downside to the market's broad reach for yield (and return), a protracted and severe housing downturn and, in turn, the effects of the subprime contagion on our economic and financial well being.

It was a lonely journey -- Nouriel Roubini was literally the only one on my investment/economic page -- and I took a lot of abuse. It hurt in many ways, and at times I felt very stupid. I tried to apply logic of argument and analytical dissection in constructing my ursine views and to dismiss the non-rigorous use of sentiment, which so many relied on to support their optimism -- after all, the trend in prices was consistently up.

With confidence in my views, I expressed my concerns in public forums -- in editorials I wrote and in interviews I gave to

Barron's

, as a guest host on

CNBC's

"Squawk Box," on numerous appearances on "Kudlow & Company," on "Mad Money," "Fast Money," "Squawk on the Street" and, of course, on the pages of

TheStreet.com's

Web sites.

As I wrote earlier, I was in a minority, one of a handful of bears seen as Cassandras in a world in which the value of nearly every asset class rose in unison.

The times are now changing as even the most optimistic observers are beginning to whistle the naysayers' tune, and recognition of the magnitude of the problem is the first stop to resolving it.

As an example, I listened to Larry Kudlow last night on "Kudlow & Company" (I will be on tonight) strike a much more sober tone than he has in the past. Sir Larry, a proponent of free-market capitalism, was, similar to Jim Cramer's

rant

almost two weeks ago, scared about the ramifications of the current credit crunch.

He went on to outline a bailout for the current crisis in which the

Fed

not only cuts interest rates but it also purchases the impaired pools of mortgage-backed securities and some of the similar instruments that have led to the current credit crisis.

Fed to Economy: Drop Dead!

I don't see any impact as yet on the real economy or on the inflation rate. Obviously, there could be an impact, but we have to rely on some real evidence.
--William Poole, President of the St. Louis Federal Reserve

Though the Fed appears to be staying on hold for now -- at least on the basis of Poole's

comments

last night -- it will likely succumb (sooner than later) to the crumbling markets and drop interest rates. This move will ultimately provide a temporary respite to the market's wicked decline, but it will only be a Band-Aid to the pervasive and growing credit problems.

TheStreet Recommends

I

summarized

the reasons for this view yesterday:

It is now clear, however, that our financial and investment world is so tightly wound and levered that the likely fallout is going to be far broader than almost anyone, except an outspoken minority, expects. What had been a liquidity problem is now morphing into a solvency problem in a wide and surprising array of assets and companies, including money market funds, Canadian trusts, cash management funds, mortgage companies, investment bankers , etc. Regardless of central-bank behavior, the price discovery in the credit markets will inevitably result in further wealth destruction, bankruptcies and an ever-increasing risk-aversion. The excessive use of cheap, mispriced credit is the source of the problem and providing more liquidity (as central bankers do) can hardly be considered a healthy solution. Our financial system is like an alcoholic who has had too much to drink -- the solution is not to serve up another round of drinks but rather to close the bar.

Resolution of the cycle, which featured an excessive misuse and mispricing of credit, will take a long time to remedy. Economically, a number of marginal lenders -- and that number has grown -- will fail. The credit contagion will reverberate in the world's economies.

At the same time, the new millennium's dominant investor, the hedge fund industry, will be disintermediated and will contract, providing a continued supply of "stuff" (bonds and stocks) that will stand in front of any durable market rally. By contrast, passive index funds will prosper in a renewal of growth.

Just as former Fed Chairman Greenspan engineered our current plight, encouraging the use of option ARMs and other mortgage teasers at the bottom of the interest rate cycle as well as overreacting to a threat of deflation by lowering interest rates to unprecedented levels, Poole and

Treasury Secretary Paulson

are also wrong in their views.

(Editor's note: A subscription is required to read the

Wall Street Journal

article in its entirety.)

The credit/economic calamity is right in front of them. I believe they will shortly come to their senses.

The Trend Is Not Your Friend

The market's decline has been set in motion. Hedge fund disintermediation, which I have

written about

continuously for months, has just started and is not likely to recede even if the Fed cuts rates and the worldwide equity markets enjoy a brief and violent recovery.

The opaque quants, the misguided and trend-following funds-of-funds and the packagers on Wall Street have all been exposed, and they will face continued redemptions and large write-offs/layoffs and continued share-price declines. The

Goldman Sachs

(GS) - Get Goldman Sachs Group, Inc. (GS) Report

Alpha Fund "save" by Eli Broad, former AIG chairman Hank Greenberg and the parent company is penny change in the monumental credit implosion. And quite frankly, as smart as the three are, they are just another group "making a bet."

Everybody hurts this time.

At time of publication, Kass and/or his funds held no positions in the stocks mentioned, although holdings can change at any time.

Doug Kass is founder and president of Seabreeze Partners Management, Inc., and the general partner and investment manager of Seabreeze Partners Short LP and Seabreeze Partners Short Offshore Fund, Ltd. Until 1996, he was senior portfolio manager at Omega Advisors, a $6 billion investment partnership. Before that he was executive senior vice president and director of institutional equities of First Albany Corporation and JW Charles/CSG. He also was a General Partner of Glickenhaus & Co., and held various positions with Putnam Management and Kidder, Peabody. Kass received his bachelor's from Alfred University, and received a master's of business administration in finance from the University of Pennsylvania's Wharton School in 1972. He co-authored "Citibank: The Ralph Nader Report" with Nader and the Center for the Study of Responsive Law and currently serves as a guest host on CNBC's "Squawk Box."