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All these plans, at first glance, seem to be good news as the increase of consumer credits would increase domestic consumption, which in turn would activate economic growth. But as soon as the decision to abandon the purchase of distressed mortgage-backed assets was announced, the indices of the US stock exchanges dropped on average by approximately 6 per cent. That was all accounted for in just one day's worth of trading. The drop also dragged down other exchanges in Europe and Asia. Why was this the case? Let's examine further.

The readers of this column may remember that, at the time US Treasury Secretary Henry Paulson announced he would propose the setting up of a $700 billion fund for purchasing distressed mortgage-backed assets from financial institutions, the US stock market, which was up until then sinking rather rapidly, recovered immediately. I also wrote in this column admiring Secretary Paulson for introducing the right measure as many financial institutions still had a lot of such distressed assets left in their portfolios, and these distressed assets were deteriorating as the prices of houses were still decreasing.

The purchase of distressed assets would prevent further financial loss, which would decrease the capital funds of financial institutions. Furthermore, the existence of a large amount of funds for purchasing mortgage-backed securities would relieve pressure on the price of such securities and should indirectly lessen the pressure on the price of houses as well. Investors saw this first measure as announced by Secretary Paulson as a perfectly strategised weapon which attacked the problem at the root of its cause. People were convinced that the strategy would work, or at least that it should work.

Even though later on when the US Congress modified the purpose of the fund to include capital increases for financial institutions, the market still did not react so negatively. This was because the amount of the fund determined for capital increases in the first tranche was only $250 billion and there was still room for other purposes including the purchase of distressed assets. Investors are still hopeful that the fund would also be used to take distressed mortgage-backed assets out of loss-ridden financial institutions.

However, as soon as the last announcement was made, to abandon the purchase of distressed assets, most - if not all -investors began to believe that hope was truly fading away. They no longer had trust that eventually there would be an effective prevention of further financial loss from still owning such mortgage-backed securities since the prices of houses in the US were still on their way down. A few hundred thousand foreclosed houses were still left unsold which would put pressure on the price of houses for a while yet. Such decreases in house prices would lead to more defaults on housing loans and thus more distressed assets for which financial institutions would have to make more provisions. This was the very ingredient that led to sudden and drastic decline in stock prices.

As for the wishful thinking of Secretary Paulson that the capital injection would lead financial institutions to resume credit extension, including consumer credits, it is likely to remain only just that - wishful thinking. It is not realistic, since credit extension does not depend only on the adequate capital fund but more so on the conditions of the economy. During the boom period when people are fully employed with good income, the ability of average income earners to make loan repayments was relatively good. Under that condition, which does not exist at this moment, it is less risky to extend consumers credit and the growth of consumer credits is always high. The increase in personal spending, as a result, would lead to higher rates of turnover in the business sector. Credit extension to businesses is also less risky and can become quite expansive over a short duration.

On the contrary, during an economic recession, which is taking form as is witnessed nowadays in the United States, unemployment increases and the sizeable reduction of stock prices has caused what can only be defined as a major wealth effect on the average household. The ability to repay loans for the typical American has reduced greatly. Extension of consumer credit then becomes extremely risky - at the household level and at the macro-economic level. Even if financial institutions are provided with adequate capital, it does not mean they will speed up their credit-extension activities, because the risk of not being repaid tends to receive a little more attention.

Credit extensions to the business sector would also not increase during the economic recession when people are spending less. The wishful thinking on the part of Secretary Paulson that credit extensions would be sped up and lead to consequential cures is therefore simply unrealistic. It would take much more time than is currently imagined by folks making policies at the US Treasury. Only when the economy has recessed to the bottom and begins to recover with the economic cycle, the credit extension process would then, and only then, gradually expand.

The last twist in the purpose of the bail-out fund worth $700 billion has undoubtedly created a damaging disturbance to this whole financial-sector rescue mission. Admittedly though, we have yet to actually see the plans and measures to shore up consumer credit markets, including credit card and car loans, which the US Treasury is still preparing. It is hoped, at least, that these mentioned plans would be more than just simple measures to reduce interest costs for borrowers since cost reduction would only reduce the burden of borrowers which theoretically in turn reduces the probability of default. The action could, however, not lead to a satisfyingly quick recovery of consumer credit markets, which is normally needed in a sustained manner. What more innovative measures would be introduced on these mentioned points and others remain to be seen. Till then we'll wait and judge.

Until next Monday.....