In the wake of the U.S. subprime mortgage meltdown, markets around the world have seen credit sources evaporate. Seven central banks, including the U.S. Federal Reserve and the European Central Bank, have collectively infused an estimated $400 billion dollars into the global financial system over the past two weeks, hoping to calm fears of a paralyzing credit crunch. But the Fed's decision Friday to approve 50 basis-point cut in the discount rate took many by surprise.
Was the cut in the discount rate, or the interest rate that the Fed charges to make direct loans to banks, merely in reaction to a temporary credit crunch -- or a sobering signal that Fed Chairman Ben Bernanke perceives deeper troubles in the U.S. financial sector? CNBC's Market Task Force and expert guests took on the question -- and offered survival advice to investors.
Anatomy of a Rate Cut
Senior economics reporter Steve Liesman broke down the essentials of the Fed's move for CNBC viewers.
He says the discount rate cut was intended as "a targeted effort by the Fed," rather than a sweeping across-the-board action. Reduced from 6.25 percent to 5.75 percent, the discount rate "remains a penalty rate" for banks.
"This was an intermediate step," Liesman said. With it the Fed asked rhetorically: "Let's see if this gets liquidity to the problem areas."
He underscored that the rate cut is not a "bailout" of floundering firms like Countrywide Financial -- which tapped its $11.5 billion credit line on Thursday -- but merely "short-term financing" to get the market moving.
How it works, from the borrowers' point of view: "I give you the security, you give me the money -- but I promise to take the security back from you," Liesman explains. Strictly speaking, he adds, "it's not a purchase."
Playing the Fed's 'Panic Mode'
Richard Bove, financial strategist at Punk, Ziegel, named stocks to play during the expected rally: "We like Washington Mutual. I think Wachovia will increase its dividend next week. Buying Goldman Sachs would give you a pretty good run," he said, adding, "Citigroup and Bank of America are all going to rally."
But the strategist posed a sobering question: "Once this rally is over, you have to ask: why did the Fed do this? They didn't do it because everything is fine and rosy in the financial system [nor due to] a short-term credit crunch. They did it because there are some serious systemic problems in the financial sector that won't go away because the Fed decided to wave a 50-basis-point magic wand."
Bove cited "a lot of atrocious lending" besides subprime loans, and believes the "deal market, the CDO and CLO markets are not coming back" -- because savvier investors now see the vehicles as riddled with hidden risks.
'Exactly The Right Thing'
Lyle Gramley, former Federal Reserve governor and now a member of the Stanford Washington Research Group, says the Fed had the right idea -- and actually took "quite a small step," rather than the radical move some saw.
Gramley says his optimism was fired by the Fed's explanation of its move: a perception that "the downside risks to growth have increased appreciably." Thus, he believes the rate cut signifies "the functional equivalent of withdrawing the [previous] bias toward tightening...and drawing the bias toward easing."
"That is exactly the right thing to do," he says. Amid wild volatility, "the markets sought leadership and the Fed stepped forward," he adds.
In a related noted, Gramley suggested a "very helpful" solution to the credit malaise: regulators should lift the portfolio caps on mortgage giants Fannie Mae and Freddie Mac as "the private-label market for mortgages is not functioning at all," and is "frozen" by illiquidity.
"Mortgage products are actually much better quality now," but "investors are scared," Gramley says. Moves like the discount rate cut can help "reverse the panic" and get investors "thinking rationally again."