Fear leads to suffering

I have argued strongly in this space for a Fed cut the last few days. Looking at trading activity the last several days, the Fed had in fact moved their target rate to 5.00%. So, at least temporarily, the Fed has in fact cut rates. Today it seems that trading has resumed at 5.25%.

I've received a fair number of comments arguing against the Fed cut. They have almost all been quality comments with what seem like reasoned positions. Some of the comments, however, seem to misunderstand either the case I'm making for Fed intervention or what the effects of a Fed easing might be for financial markets. So I thought I'd take a little time to clarify my view in the form of a Q&A.

1) When you say the market is highly illiquid, what does that mean exactly?

Right now its impossible to trade large numbers of bonds. I'm not talking about housing related stuff. I mean its impossible to trade many plain vanilla bonds. Those you can trade have become much more expensive to trade, because the bid/ask is wider.

For anything housing related, forget it. There are no bids.

2) Why should I care about illiquidity?

The problem comes in where good bonds cannot be sold at any price. Read that last sentence carefully. It isn't the Fed's problem if risk spreads widen. It isn't the Fed's problem if bonds default. It isn't the Fed's problem if banks make bad loans. It is a problem if good bonds cannot be sold at any price.

If a bank has underwritten a series of fixed-rate, fully documented, first lien, prime jumbo mortgages but cannot sell them into the bond market, then they have to keep the loans on their balance sheet. That takes up capital that would otherwise be used for other loans. Basically the jumbo mortgage market grinds to a complete standstill.

3) But the conforming limit is $417,000! Why should we care about bailing out these fat cat home owners? They were stupid enough to buy into a bubble market! Why not just let the price of homes fall and solve the problem that way?

First of all, middle-class homes in many large metropolitan areas, particularly on the East Coast and California, are north of $500,000. So jumbo loans are not just for the rich.

Second, the "let the price fall" idea is fine and good, but there still needs to be a functioning market in order for that solution to work. For example, let's say I bought my house for $700,000 last year. Let's assume that price was too high, merely the result of a housing bubble in my area. But what should the house really be worth? We can't know unless the market is allowed to function. Maybe $650,000. Maybe $600,000. Maybe $400,000. If no one can get a mortgage against the property, then I can't sell the house at all.

The corollary to the tech bubble would be to conclude that everyone who bought Yahoo stock in 1999 were idiots. We should therefore shut down the NASDAQ entirely. Don't allow those greedy tech stock buyers to sell their stock at a loss. Don't allow them to trade it at all. Does that make any sense?

4) (Actual comment from Darth Toll who wins the "Best Screen name" award for 2007, in response to me comparing the market to an irrational bank run)

Are you trying to say that there is no logical basis for this fear, kind of like a "the only thing we have to fear is fear itself" thing?

The fear surrounding sub-prime securities is well founded, obviously. The fear surrounding homebuilders is well founded. The fear surrounding prime mortgages with full income documentation and 20% cash down payments is unfounded. Well, maybe not completely unfounded. Maybe those bonds should trade wider than they have in the past because the likely recovery rate is a bit lower (due to weak HPA) than history. But for there to be absolutely no liquidity? Untradable at any price? The housing market just isn't that bad people. Not every mortgage underwritten in 2007 is going to default. It really is time to separate legitimate fears from pure paranoia.

5) Why should the Fed cut rates to bail out sub-prime lenders/homebuilders/hedge funds? If they made bad loans, why shouldn't they just go bankrupt? Banks should learn a lesson about making bad loans.

The Fed injecting liquidity won't do a damn thing to help hedge funds and/or financial institutions suffering real losses from bad loans. New Century is bankrupt and they are staying bankrupt. BSAM's funds are worthless and they are staying worthless.

Nothing the Fed is going to do will make delinquent borrowers current again. Maybe lowering interest rates will prevent a small number of defaults because resets will be lower, but all of these NINA and liar loans are going to go bad no matter what. I mean, there are loans that go bad and there are just bad loans. No one is going to save banks that made too many bad loans.

But say there is a prime mortgage originator who borrows short-term to underwrite their loans? Now they cannot securitize their prime jumbo loans, and therefore cannot repay their short-term facility. Do we want to drive institutions like this bankrupt merely because the market fears all mortgages? What "lesson" is that teaching and to whom?

6) Easing policy now is too risky. The Fed will just create another bubble, basically delaying the ultimate pain. Why not just take our lumps now and get on with it?

This is a very fair question, and a tough one to counter. I keep thinking back to 1998, which as I've written has a lot of parallels to today. In July 1998, the Fed had a tightening bias. In September they cut 25 bps. In October they cut another 25bps intra meeting, then cut again at the November meeting. By spring the LTCM crisis had largely passed, and credit spreads
had mostly recovered. In June 1999 they were hiking again.

Some say the Fed exacerbated the tech bubble by cutting in 1998. I disagree. As evidence I look at credit spreads, which widened substantially in the Fall of 1998 and never got close to pre-LTCM levels until 2004. It wasn't easy money in the debt markets that allowed the tech bubble to continue. Now we will never know whether they Fed could have engineered a better outcome during the tech bubble had they taking an alternative approach. So it might be fun to debate, but I think we can agree there will never be a real "answer."

While we're on the subject of Long-Term Capital Management, that "bail out" that the Fed engineered was only a real bail out of the financial system, not a bail out of the fund. The fund shareholders were wiped out. The bail out really only prevented contagion as well as protecting the creditors from suffering through a liquidity crunch as they all tried to beat each other to the door.

Please feel free to comment.