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.