The United States is now waging an all-out war against clogged credit markets and attacking each troubled artery head on.

Earlier this week U.S. government officials announced a new plan to pump $800 billion dollars into the rapidly contracting economy by injecting funds into distressed credit markets where banks remain reluctant to lend and continue to hoard cash.

Unprecedented, this latest salvo has been fired by the Federal Reserve, which has clearly stretched its Constitutional authority in its attempt to stabilize U.S. capital markets over the last 16 months. This action is largely aimed at finally bringing long-term mortgage rates down ??? and it???s working. Benchmark 30-year fixed-rate mortgages have dropped to 5.70% from 6.41% four weeks ago.

Also, the government will inject up to $200 billion dollars to attack the deflation now underway in the consumer sector, deploying financing to investors buying securities tied to student loans, credit cards, auto loans, and small business loans.

In the absence of a broad-based policy initiative to tackle the ongoing mortgage-backed crisis clogging bank balance sheets, the U.S. Treasury is sending mixed signals to market participants.

What Happened to TARP?

Will the United States eventually create a fund or pool to stabilize toxic assets freezing inter-bank lending? Treasury now prefers to channel TARP (Troubled Asset Relief Program) funds directly to bank coffers instead of creating a pool to lump toxic assets and create a platform to trade these largely illiquid and worthless mortgage assets.

Secretary Treasury Hank Paulson???s original TARP plan has been revised since mid-November causing all sorts of market uncertainty; the government now plans to deal with the growing crisis affecting consumer credit markets while seemingly abandoning its original goal to tackle illiquid mortgage-backed securities. Instead, Paulson would rather keep his powder dry for the next blowup.

Perhaps the government is balking at collateralizing an asset class that is still declining in value. Synthetic mortgage-backed securities continue to lose value in late November following Paulson???s TARP reversal. Any hope for cleaning up this mess has now been shelved or delayed until President-elect Obama comes to power in January with his newly appointed team, including former Federal Reserve Chairman, Paul Volcker.

Diversion of Funds

Central banks continue to create sufficient liquidity to keep the banking system afloat but banks aren???t confident enough to pass on that precious liquidity. The reason why LIBOR is still elevated is the diversion of funds away from buying toxic assets to the consumer sector. This is an impediment to a sustained improvement in the interbank (LIBOR) market.

Three month LIBOR remains elevated at 2.18% compared to a 1% Federal Funds rate; prior to the subprime crash in August 2007, LIBOR stood about 15 basis points (0.15%) above LIBOR. On October 9, LIBOR peaked at 4.84% before compressing. Still, LIBOR is too high.

If the government would deal head-on with the securitized mortgage problem still plaguing bank balance sheets then, perhaps, taxpayer???s would not have to finance yet another in a series of expensive loans to consumers and small businesses.

Since September, the Federal Reserve has expanded its balance sheet by more than $1.2 trillion dollars and continues to aggressively expand credit into the financial system. Yet despite these bold efforts, most banks are hoarding TARP disbursements and refuse to lend. If these efforts fail to make headway then it???s highly probable the Fed might start lending directly to businesses and, possibly, consumers.

Obama and the 2009 New Deal

Cleaning up this humungous financial mess will take time. President-elect Obama???s plan to spend $2.5 trillion dollars in infrastructure projects in 2009 will help to unwind falling prices, but it won???t cure the disease.

I suspect this gargantuan spending initiative will help to stabilize the economy for a few quarters but ultimately won???t act as a panacea to drive long-term consumption. Consumer sentiment sits at its lowest levels since 1980 with core assets in housing, stocks and bonds purged since September forcing Americans to spend less and raise domestic savings rates.

FDR???s New Deal in 1933 was followed by a second New Deal in 1935. It didn???t end the Great Depression; WW II finally rescued the American economy as production boomed starting in 1942. The New Deals (I and II) provided a major stimulus and probably rescued the economy from its lowest depths in 1937; without a major global conflict it???s highly unlikely American industry would have recovered.

Deflation is widespread as consumer prices start collapsing worldwide led by plunging commodities, namely oil and wholesale prices. Only wage growth remains in the plus column in late 2008 but might be poised to turn slightly negative in 2009. Once wages turn negative, it???s ???ballgame over??? for consumption.

Treasury???s Reversal Demands Cautious Outlook

In the absence of a well defined and implemented TARP plan to purge bad assets, credit stress will remain entrenched in financial markets. Banks will remain reluctant to lend. Counterparty trust is still highly fractured and, as a result, banks are only grudgingly beginning to lend.

There is absolutely no credible case to be made for a new bull market. True, stocks are certainly much cheaper compared to 12 months ago and many pay big dividends. But equities are considered only ???fair value??? and historically have sold for less than book value towards the end of a bear market. That???s not the case now.

Busted credit markets, however, should be accumulated now starting with convertible bonds, investment grade corporate bonds and TIPs, or Treasury Inflation Protected Securities. These assets have crashed since September and trade at or near all-time low valuations.

A secular bull market for stocks won???t begin with consensus earnings at these levels, a busted and despondent American (and global) consumer, a total collapse of asset values impacting consumption (housing, stocks) and rising unemployment. What???s more, we???re in unchartered economic territory amid the first credit bust in 78 years; it would be unwise to underestimate the duration of this crisis and the time required to finally segregate and quash bad assets.

Finally, and most importantly, the heart of this credit crisis lies in the distressed U.S. housing industry where trillions of dollars??? worth of mortgage-backed securities tied to toxic derivatives are still declining in value.

The price of previously sold homes fell in October by the biggest amount in 40 years, down 11.3%.

The market will not favorably respond to any government efforts to end this crisis until housing values stop declining or, at least, begin to stabilize. This is perhaps one reason why Treasury Secretary Paulson balked at his original TARP plan (Troubled Asset Relief Program) two weeks ago; the government is reluctant to collateralize a falling asset.