Praying for a Rate Cut and Missing the Point

by: Markham Lee

After the acceptance by many last week that we do in fact have a Credit Crunch and that the markets are headed for trouble long-term, many are now praying for a rate cut on Tuesday. Like children on Christmas Eve, many are hoping that Father Christmas Bernanke will provide the salvation of a rate cut. I think the investors and analysts who are praying for this result are missing the point and are actually wishing for actions that will make things worse.

High rates aren't the problem. When a lender originates a loan, they're effectively investing their money with the borrower, and are expecting to see a fixed rate of return AKA the loan's interest rate. In other words this problem was caused by lenders using poor judgment and making a series of bad investments: originating a series of risky loans to borrowers who weren’t able to pay the money back.

The problem with lenders originating bad loans was compounded by other investors buying these ill-fated loans in the form of debt securities (CDOs and Bonds); things got even worse when the CDO and Bond investors improperly valued these investments via mark-to-model methods (AKA "what I hope this investment will be worth"), borrowing money against them, and then getting over-leveraged. When various institutional investors were finally forced to value things properly, it led to debacles like Sowood Capital Management, American Home Mortgage and the collapse of two (and now possibly three) Bear Stearns Hedge Funds.

At the end of the day, lower rates won't prevent people from having to face the consequences of making bad investments and getting over leveraged, nor is it the job of the Fed to ensure that investors who made stupid decisions continue to make money and not lose their shirts. Lowering interest rates and increasing the money supply is what led us down the path to creating a credit bubble in the first place. Lowering them again isn't going to help matters, it's only going to make things worse and lead us down the path towards an even greater calamity. Lower interest rates will not reduce the default rates on mortgages, it won't suddenly increase the value of investments in credit maligned pools of mortgage based securities, and it won't make it "safe" for banks to return to the practice of originating risky loans (be they mortgages or corporate financing) just to satiate the market's credit worries.

Instead, there needs to be a wholesale re-examining of the business practices that got us into this mess with safeguards, policies, and new best practices put into place that will lead us towards healthier debt markets in the future. Playing the "rate game" as a short-term cure and ignoring the root cause only guarantees we'll face a worse situation in the future. There is no free lunch; you can't make bad investments and enjoy the good times whilst they last and then ask the Fed to bail you out for creating a mess.

If the Fed cuts rates on Tuesday, expect the market to roar back, as the stocks of homebuilders, lenders, retail banks and brokerage firms skyrocket. Don’t get caught up in the enthusiasm, as it’s only delaying the inevitable as the problems of housing supply, loan defaults, poor debt securities investments, etc, won’t go away due to a rate cut. However, for savvy investors it will be an opportunity to “get short” on equities that have deep seated credit crunch related issues, after all, no matter what the market does, the smart investors always make money.