Fed Can't Unfreeze Credit Just by Cutting Rates

It’s not the economy, stupid.

It’s the credit crunch.

The Federal Reserve’s 75-basis point cut in interest rates Tuesday may help stimulate a sluggish economy. But like the several cuts before, it is unlikely to unfreeze the credit markets, especially the mortgage one.

Credit Crunch

And as the Fed continues to use its conventional fire-fighting equipment,there’s a growing sense that extraordinary--and somewhat controversial--measures may be needed.

“The Fed by itself will not get us out of it," says John Irons, research director at the Economic Policy Institute. “We need to combine fiscal stimulus with monetary stimulus.”

Among the ideas now emerging are a new fiscal stimulus measures, specifically targeting the mortgage market, and the possibility that a bailout of both business and consumers may be inevitable.

“The bulls eye of this crisis is the mortgage market,” Sen. Charles Schumer, chairman of the Economic Policy Subcommittee, told CNBC Tuesday. “Everyone knows we need to do more to stabilize housing.”

“It doesn't matter how low rates go, if you are a financial institution, if you think the home is worth the less than the mortgage or if you're worried the homeowner is going to pay back the mortgage,” says Dan Mitchell, a senior fellow at the Cato Institute.

Look at Bear Stearns. It may be no coincidence that the biggest casualty on Wall Street thus far was suffocating under a blanket of mortgage-backed securities.

It may also be no coincidence that the Fed last week took the unusual step of creating its so-called Term Securities Lending Facility, allowing it to take up to $200 billion of non-Treasury securities, including federal agency backed mortgage securities and mortgages, as collateral for up to 28 days.

“It’s probably an admission that federal funds will not be enough," David Resler, chief economist at Nomura International, said at the time. Reseler considers the lending facility, the “most significant policy initiative since the credit crisis began last August.”

But it may be as far as the Fed can go. Federal law prevents the central bank from buying mortgages outright. Congress, of course, could change that, or otherwise, empower another arm of the federal government to do that.

“The most effective way is to create some way so the federal government can force a markdown in some of these mortgages and take them on itself -- say through some sort of bank -- such that the government becomes the holder of mortgages," says Irons.

Interest rates on mortgages have remained surprisingly high despite the sharp decline in short-term rates. At one point, the spread between the 10-year Treasury and 30-year mortgages jumped from 160 basis points to about 240 basis points, discouraging borrowers, who were under the impression that the economy was headed toward recession and lower rates were intended to spark lending.

The 1990-1991 recession was short and shallow. On top of the Fed’s action -- which included a stunning one percent cut in the discount rate -- regulators and legislators hatched a strikingly successful rescue plan for the savings and loan industry, which was suffering its own lending meltdown.

Federal Reserve Bank Chairman Ben Bernanke
Pablo Martinez Monsivais

A newly created federal corporation in essence took responsibility of billions of dollars of bad loans and devalued real estate assets, which were then auctioned off to private buyers.

This time, the government’s efforts are arguably ill-conceived and misplaced, say economists. The $172 billion stimulus package is likely to provide little of a boost. It contains one-off tax cuts, which typically lead to consumers saving the money, and lacks traditional measures such as an extension of jobless benefits and infrastructure spending. Most importantly, it did not address the slumping mortgage market beyond raising the borrowing limits on federally-backed jumbo loans.

Bernanke himself has suggested some kind of markdown in mortgage principal--a signal, much like his hearty endorsement of a stimulus package--somewhat unusual for a Fed Chairman -- that he thinks the central bank needs help.

Last Friday, hours after moving to provide emergency funding to Bear Stearns, Bernanke was talking up tougher mortgage lending regulations and explaining how the Fed was “addressing the foreclosure crisis in capacities other than that of a regulator” in a speech to the National Community Reinvestment Coalition, which happens to be urging the government to buy mortgages at a discount through an auction.

On Capitol Hill, House Financial Services Committee Chairman Barney Frank is the latest to push the idea of federal intervention and support, through some sort of loan guarantees.

Other proposals include temporary foreclosure relief and the refinancing of subprime loans. Sen. Schumer Tuesday called for an easing of capital requirements for Freddie Macand Fannie Maeand floated the idea of tax credits for homebuyers, while repeatedly referring to a “crisis of confidence.”

He is has plenty of company in saying that. Lending is all about confidence and trust.

“I think it is an issue of the financial system overwhelming the rest of our U.S. economy,” Vanguard founder John Bogle told CNBC.

Bogle, for one, seems to be worried about the Fed's own balance sheet and sees taxpayer money at stake. “They can't do everything,” he said.

Or as Resler puts it, the Fed “may have enough ammunition, but it’s arsenal may not be big enough.” 

In a presidential election year, however, it may be more politically desirable -- as well as easier -- for the Fed than for the Congress to throw good money after bad.

And though bailout may be an usually dirty word at the moment, there were few howls Monday decrying the Fed’s intervention in the Bear Stearns case.

Much like the debate over the Fed’s role and the idea of moral hazard, an argument whose intensity has waned as fear of the credit crunch has heightened, hand wringing over an outright government bailout may turn into an open-hands expression of helpless inevitability.

At this point, the moral hazard issue may be solely “theoretical,” as Irons puts it, because we are “stuck” with the credit crunch and a bailout. “This is a once in a generation thing,”