The Consumers Union, an advocacy group associated with Consumer Reports, recently reported that Bank of America had announced interest rate increases on credit card debt that could approach 28%. As a consumer advocacy group, we would expect considerable emphasis on a possible 28% annual interest rate along with a comment to the effect that big commercial banks with credit card operations may look to make up some of their residential mortgage losses by increasing interest income from credit cards.

However, one could argue that such interest rate increases simply reflect increasing risk among a lender’s credit card portfolio, since most macro-economic statistics and specific credit card default experience suggest increasing difficulties on the part of borrowers in properly servicing credit card debt. In effect, the argument goes, lenders are attempting to properly price for risk, a dictate in the credit world as old as time (but rarely followed).

Nonetheless, the point about offsetting losses is certainly interesting and quite likely an accurate expression of intent. After all, in running any type of business, if one product or service falters, management invariably attempts to counter adverse fallout by focusing attention and resources on other potential bright spots in its product array.

The issue, of course, is how bright the prospects might be for generating significant additional interest income by hiking credit card interest rates. The short answer appears a bit discouraging, on the one hand, but encouraging on the other.

The bad news first. Credit card debt increased by $20 billion in the 4th quarter of 2007. By comparison, credit card debt increased about $6.25 billion a quarter throughout 2004. The reason? Consumers are locked into life styles, and the cash cow – home equity – has largely disappeared. They’re forced to turn to credit cards as their additional debt source. Credit card debt is approaching $1 trillion, which is not far behind the level of auto loans but still a far cry from the current $11 trillion of residential mortgages. Household debt – primarily residential mortgages, auto loans, and credit card debt – is now at 133% of disposable income according to information from the Center for Responsible Lending. Consequently, it would appear that credit card lenders are bumping up against the consumer’s ability to support such debt levels. Higher interest rates only adds to the consumer debt burden and may accelerate a rush to the tipping point – something like resetting residential mortgage rates and throwing the borrower into default.

But now the good news. Many credit card users pay off their balances monthly, at least in good times. These users may represent the lifeline to respectable profit performance for credit card lenders if a slowing economy forces this set of consumers to carry credit balances from one period to the next. Since there are virtually no limitations on the level of interest rates a credit card lender may charge – 28% seems as good as another other rate – why not benefit from those relatively affluent consumers who are now pushed into the costly position of carrying credit card balances, which may increase from period to period as purchases and accumulated finance charges accumulate ever so rapidly?

It’s little wonder the recent Visa public offering was such a smashing success.

The Office of Federal Housing Enterprise Oversight recently announced a decrease in required capital per dollar of loan assets for Fannie Mae and Freddie Mac, which, in effect, allows those two institutions to buy, roughly, an additional $600 Billion of residential mortgages. The combined capital base of both institutions presently supports about $1.4 Trillion in residential mortgages or mortgage guarantees. The new capital guidelines translate to an upper asset limit of approximately $2 Trillion – a $600 Billion increase.

This event raises some interest scenarios and associated dynamics. Originate-and-sell, which had been on the shelf for several months as a guiding lending policy, may now experience a second life for some segments of the residential mortgage market. Sellers, sitting on questionable residential assets, have a great incentive to sell, particularly those assets with the greatest potential to pollute their portfolios. Further, a moribund buyer – Fannie Mae or Freddie Mac – suddenly has the capital to buy and certainly the policy encouragement to do so.

Even with new buying capacity, both Fannie Mae and Freddie Mac may be somewhat reluctant to exercise their respective muscle. Fannie Mae lost $5.8 Billion over the last two quarters in 2007. Freddie Mac wasn’t too far behind at a $3.7 Billion loss over those two quarters. The culprit in both instances was, of course, residential mortgages purchased from loan originators – and presumably quality mortgages at that.

Note, too, that both Fannie Mae and Freddie Mac are publicly traded companies. Their shareholders may express little enthusiasm for added assets that loan originators wish to unload, especially in view of recent unprecedented losses and the ensuing impact on stock price.

It should be interesting to watch. The loan originators, especially commercial banks, have every reason to get suspect toxic waste off their books before they are compelled to mark to market. Fannie Mae and Freddie Mac have equally as compelling reasons to use their newly acquired lending capacity for investment in quality assets.

And establishing quality may be a daunting task. $600 Billion in additional loans may roughly approximate 1.7 million residential mortgages. Consider the overwhelming task of verifying current borrower information, such as employment, income, and debt obligations for 1.7 million borrowers. The institutions may, of course, rely on the loan originators and their assertions of compliance. Unfortunately, we know how well that works in an originate-and-sell environment.

The Secretary of the Treasury recently announced a series of reform recommendations that would presumably work to alleviate the present financial and credit crisis as well as preclude future crises of such magnitude. On closer reading, and with the economy in or slipping toward recession, the recommendations are most relevant to prevention rather than cure.

At the top of the list is closer regulatory supervision of mortgage lenders by state and federal agencies. Another priority recommendation urges state financial regulators to implement more rigorous licensing standards for mortgage brokers.

There is more than sufficient blame to spread around for the current crisis. Granted, state and federal regulators should have focused more acutely on the collapsing underwriting standards of mortgage lenders. And, granted, mortgage brokers should follow some prescribed set of ethical standards in generating deals.

It seems, however, that no mortgage lender in its right mind would make or purchase liar loans unless it knew it could pass them on immediately to another, more rapacious party (although there are billions of dollars of evidence that a few mortgage lenders were not in their right minds). No mortgage broker in his or her right mind would generate liar loans if he or she did not know there was a ready market for such toxic waste.

So why were there willing third parties eager to scoop up and process liar loans, of any variety, as soon as they appeared? The reason is simple and gets to the heart of the matter. Consolidators such as Citigroup and Merrill Lynch found they could package liar loans with credit quality residential mortgages and sell the repackaged debt as mortgage-backed securities, if the credit rating agencies could find a way to apply their AAA stamp of approval to these hybrid securities.

And, presto, the credit rating agencies did find a way to do so, agreeing to accept the fees offered by the issuers for their assurance of the highest credit quality. Several small towns in Norway, for example, can’t pay many of their municipal expenses today, after investing in mortgage-backed securities. But the fault lies not with an unethical and aggressive mortgage broker in California, who passed his or her deal to a mortgage lender, who passed it on to the mortgage-backed securities assemblers and packers, who requested a high quality credit rating from one or more of the three established credit rating agencies. At its source, the fault lies with the credit rating agencies. Without their AAA ratings for this garbage debt, the present crisis would be far less extensive and far less severe.

The credit rating agencies were indeed mentioned in the set of reform recommendations. But the answer seems to be self-policing, along with the application of more prudent standards. As a confidence builder, there seems to be something missing.

There seems to be a prevailing sense that liquidity, credit, and economic activity are closely related. More liquidity means more credit. More credit means more spending. More spending means more economic activity. Therefore, we can’t go wrong as long as the Federal Reserve keeps pumping more liquidity into the financial system – perhaps at an accelerating rate for good measure.

The evidence seems to bear out this line of reasoning. The Federal Reserve just announced it will pump $200 billion of additional liquidity into the financial system to ease the credit crisis. Wall Street responded with gusto. The Dow jumped by 416 points, its biggest one-day increase since July 2002. Perhaps by coincidence, the quarterly Anderson Forecast from the University of California at Los Angeles concluded that the U.S. economy is unlikely to slip into recession after all.

To put these very current events in some perspective, let’s recall the negative forces at work in the U.S. economy identified by the Economist in November 2007.

• A collapse in housing construction;
• A drop in corporate profits;
• A steep and continuing drop in housing prices;
• An emerging drop in stock market prices;
• A sharp increase in oil and, subsequently, gasoline prices;
• A softening labor market; and
• An existing – and likely accelerating – credit crisis.

Think back over the last four months and identify which of these negative forces have abated and which have intensified. If the forces have intensified, then there is even more pressure on the healing powers of liquidity.

If $200 billion of additional liquidity can re-establish home values, restore stock market values, reinvigorate the slumping job market, and drive household debt below 120% of disposable income (the current level), then we should weather the storm by virtue of an increase in credit quality.

A credit crisis is usually founded on a profound concern about debt service prospects that spans many markets and borrowers. The consumer, you’ll recall, accounts for about 70% of gross domestic product. Residential housing and stock market values were the two collateral assets the consumer could turn into cash to supplement disposable income in servicing debt – at least until the mid point of 2007. If more liquidity is the answer, it seems it must address and enhance the credit quality of the consumer above all. But can it do so?

We’re presently saturated with information about the sub prime crisis, rising defaults and foreclosures, a massive slump in new home sales, and so on. Further, we’re all acutely aware of the increase in oil prices and the price of gasoline at the pump. And now we learn that wheat prices have been accelerating for the past year with additional adverse implications for the economy.

Since March 2007, the price of wheat has risen from roughly $5 a bushel to approximately $11 a bushel today. The price has doubled, in effect. As a result, a 50-pound bag of flour that cost $14 a year ago costs $28 dollars today. For those running a bakery or operating a pizza parlor, this puts severe pressure on profit margins in business segments characterized by low profit margins.

In good times, bakeries and pizza parlors might pass on the increased costs in the form of higher prices. But these aren’t good times. The economy is softening. The labor market is softening. The unemployment rate and new unemployment claims are increasing. There is very little retail price flexibility for the average baker or pizza chef.

Increases in wheat prices and oil prices, interestingly, are not unrelated events. Oil prices are linked, in part, to the fate of the U.S. dollar. Since oil is priced on the world market in dollars, oil becomes cheaper for foreign buyers as the dollar decreases in value vis-à-vis other currencies – which tends to push up demand and, therefore, the price of oil in dollars. Higher oil prices stimulate development of bio fuels such as ethanol. But the push toward ethanol encourages farmers to set aside wheat acreage in favor of corn in order to produce more corn for conversion into ethanol. Consequently, the local bakery and pizza parlor find themselves feeling the pinch as wheat prices increase in partial response to the increase in oil prices.

On the one hand, an increase in domestic commodity prices, such as wheat, is certainly good for the domestic wheat producer. On the other hand, those price increases work their way very quickly into the mainstream economy, squeezing profit margins, or squeezing consumer spending if retail prices increase. Either way, the implications for the economy are hardly positive. Further, the Federal Reserve finds itself between a rock and a hard place in attempting to inject more liquidity into the economy via further interest rate cuts without pouring more fuel on inflationary pressures from increased liquidity.