The Hindu Business Line : 50 bps cut: More than meets the eye?

The situation is comparable to (and probably worse than) the S & L crisis of the eighties, which ultimately resulted in a Government bailout costing hundreds of billions of dollars.

S Balakrishnan

At last the cat is out of the bag and the guessing game is over. The Fed cut its Fed Funds and discount rates 50 bps each on Tuesday. Global stock markets soared. Is the market euphoria justified?

The explanation for the market’s jump is straightforward. Finance theory tells us stock prices are nothing but future earnings discounted at the risk free rate of interest. If, as has happened, the discount rate is 50 bps less, post-rate cut, stocks are worth more.

But there could be a hidden message in the Fed cutting more than the expected 25 bps. The general impression is that the main sufferers in the recent mortgage losses are the ‘fat cats’ – hedge funds , in which only the wealthy invest.

But the special purpose vehicles (SPVs) set up to invest in mortgage collateralised debt obligations (CDOs) are predominantly bank-financed, with the CDOs themselves as collateral! Thus, the biggest casualties could be the banks holding doubtful collateral, and not investors. The inescapable conclusion is that there is significant systemic risk.

Skeletons in cupboard

What could be the skeletons in the market’s cupboard? One suspects the Fed’s fear is that some global financial institution could go belly up. Rate cuts will revive ‘good’ assets, but no amount of virtual (collateral-free) liquidity can redeem assets gone bad. Foreclosures are at record levels and we ain’t seen the bottom or end yet.

The Fed knows this. It is more of a worry for the central bank- and indeed all central banks - than the credit market seizure. A recession at least has a central bank solution – ease interest rates as much and for as long as necessary. But how do you deal with loss of confidence in banks, not to speak of the financial system turning credit-shy?

S&L crisis

The situation is comparable to (and probably worse than) the S & L (Savings and loans) crisis of the eighties, which ultimately resulted in a Government bailout costing hundreds of billions of dollars for there are problems beyond the central bank’s remit and powers.

The S&L rescue happened in the bastion of free markets and in the tenure of that most free market of presidents – Ronald Reagan.

Is the same fate in store for Mr George W. Bush?

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