The Federal Reserve Cuts Rates By A Surprising Half Point. Be Afraid.

Posted by: Bruce Nussbaum on September 18, 2007

The markets rallied on news that the Fed cut its key benchmark rate by a surprising 1/2 point, not the expected 1/4, reflecting the convention wisdom that this will solve the current financial and housing crises. I wish this were true but an innovation in finance—structured finance—makes the fed move unlikely to curb the decline anytime soon. Fed Chairman Bernanke was bold in cutting rates so much but his move underlines the seriousness of the situation.

In the past, when we had financial crises, cutting interest rates worked because they helped banks who could extend loans to troubled firms. This time, the problem is not with the banking system but with securities made up of pooled mortgages. Thanks to financial innovation, these kinds of structured pools of mortgages, sliced and diced in a million ways, have come to underpin much of the financial and banking system around the world. That’s why there is a huge run on the banks going on in London right now.

The markets for those pools have frozen up in a panic and it’s not clear how they will be unfrozen. Securities once rated triple A have been downgraded to triple C. The reason is it turns out that people don’t really know what is in those pools of mortgages. They don’t know how bad the situation really is. And until investors can unravel them and reprice them down, the financial markets will be in trouble.

So innovation in the financial markets has put us in a real pickle. The crisis wasn’t supposed to happen. All the experts, including Fed Chairman Bernanke said that problems in structured finance would not spread to the entire global financial market. It has. The experts said that the structured finance crisis would not spread to the housing market. It has. The experts said it would not hurt the banks. It has. What else are the experts missing?

Cutting interest rates may be a necessary policy move, but it isn’t sufficient. Be afraid.

Reader Comments

Sean

September 18, 2007 10:07 PM

I believe a half point cut may worsen this problem. The US has to draw in huge foreign investment everyday and cavalier monetary policy is just the sort of thing to risk foreign investors fleeing dollar denominated assets. There was a surprisingly low demand for long treasuries at the last auction -- something like 1/5 of what was expected.

The dislocation in housing and the credit markets is too severe to affect with rate cuts. A person making $70K a year whose $800,000 option ARM is going to adjust from a payment of $2,500 a month to $5,000 a month is not going to be saved by a rate cut that makes the payment $4,500 a month.

An interesting article a little more than a week ago revealed that the huge foreclosures to date have been almost exclusively on loans THAT HAVE NOT ADJUSTED RATES YET! So in the example above, it would mean that our $70K a year earner is defaulting on the $2,500 a month payment, which either has a teaser 1% interest rate, a negative amortization payment, or some other "affordability" device that delays actual payments for a few years.

That is stunning and illustrates how far this has to go.

Most people don't realize it, but without foreign investors, the US credit markets are toast -- long rates will end up past 9%. The US doesn't have any savings, only debt and now isn't the time for Americans to try to accumulate what is missing.

The Fed just disrespected China and a few other very large creditors. Let's see if they show up at the next debt auction.

Manish

September 18, 2007 10:09 PM

I agree with the author. The fact that Fed has to cut 1/2 % on both sides indicates the underlying problem of US economy. It would be wise to just wait and watch as companies post their results for the qtr.

Pete Plum

September 19, 2007 12:50 PM

I agree. However, doesn't this post contradict one of your other recent posts in which you laud Greenspan as a great innovator? He was at the helm when much of this problem - which I think you deserve credit for stating clearly and rationally - was founded.

I know this blog is design/innovation focused, not finance, but I found this funny.

Bruce Nussbaum

September 19, 2007 1:13 PM

Pete,
You are right. Life is complicated. How much responsibility Alan Greenspan has for the current mess is very much an academic, policy and political question. Greenspan was great on productivity--and in the end, that may be his defining historic moment. And he probably should have begun to raise interest rates earlier and faster to deal with the asset bubbles. He didn't because he feels it is easier to deal with bubbles after they pop than before. This is a fascinating issue--that few enter. At least Greenspan thinks about, even if he may be in error.
Bruce

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Want to stop talking about innovation and learn how to make it work for you? Bruce Nussbaum takes you deep into the latest thinking about innovation and design with daily scoops, provocative perspectives and case studies. Nussbaum is at the center of a global conversation on the growing discipline of innovation and the deepening field of design thinking. Read him to discover what social networking works—and what doesn’t. Discover where service innovation is going and how experience design is shaping up. Learn which schools are graduating the most creative talent and which consulting firms are the hottest. And get his take on what the smartest companies are doing in the U.S., Asia and Europe, far ahead of the pack.

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