At the risk of sounding out-of-touch by being cautiously encouraged by the pummeling the market has taken over the last month, this is not the time for the Fed to subsidize the financial lending industry or lower the funds rate (and by extension the prime). Lenders are being hammered today for years of easy money, at a time in which too small a return was demanded for the amount of risk being assumed. That profligacy is being answered for. To cut the funds rate would be to subsidize these lenders and effectively push the needed tightening further down the road.
Your local bank makes loans across the spectrum, from subprime to full covenant. In order to garner a greater number of subprime borrowers, it offered historically low rates for the risk involved, errantly presuming the real estate market would continue to zip along at double-digit annual growth rates indefinitely. Consequently, when subprime borrowers began defaulting on their mortgages back in late May and early June, the bank did not have an adequate number of on-time subprime borrowers (nor were they being charged high enough rates) to cover the losses.
What does the bank do? It stops making as many subprime loans, demands more for them, and moves adjustable rate mortages upward. The bank's not doing this simply because it feels necessitated. The institutions it borrows from (like NewAlliance), and the institutions they borrow from (like Citigroup), have in turn raised their rates across the board as well. This trend is self-perpetuating, as the rising rates make it more difficult for other subprime and alternate lenders who are on the cusp to stay ahead.
Parenthetically, it's sad that upwards of seven million people may have to default on their home mortgages. But for many overextended borrowers, a default is a blessing over the long-term. Many of these borrowers are paying far more in interest than they are in principal, acquiring almost no equity while spending nearly every penny they have. The real estate bubble, more so even than the tech bubble before it, unleashed unrealistic expectations of impossible growth (we're talking about wood and nails, not seismic technological leaps, after all). Looking off on the horizon, a sobering adjustment is best.
A funds rate increase makes money easier to come by as the banking industry is trying to make it tougher. Essentially, the effect on the local bank is more money for lending purposes and artificial relief for subprime borrowers in over their heads. We're back where we started, with people taking out loans they can't (and should not attempt to) pay for.
The stellar economic growth that has taken place since 2002 has been primarily fueled by unjustified, stellar real estate performance. As more people have taken out loans, prices have been pushed up. But that upward pressure has come by paper wealth. The growth has been built in part on a house of cards. With reality catching up, the markets have taken a beating.
Why is this problematic? Besides excess volatility being bad for innovation and entrepreneurial activity, such a focus on new condos, second homes, and beach resorts is not the way for the US to remain on the cutting edge of the global economic and technological arenas.
And it's simply not sustainable. An example I've used several times previously, as to why:
I make $30,000 a year working. I spend $40,000 a year buying consumables (stuff that doesn't represent a future monetary benefit). I've been doing this for five years. Fortunately, I own a house that was worth $100,000 five years ago. Every year over the last five its value has been increasing by $11,000. To feed my consumption habits, I've been taking out a home equity loan for $11,000 on an annual basis. Thus, my net worth has been up $1,000 ($30,000income-$40,000spent+$11,000equity) for five years running.That eventuality appears to have now arrived.
But what happens if the value of my house crashes? Or just stops appreciating? My standard of living will have to be adjusted downward drastically. If not, I'll fall into debt and the whole miasma will be compounded by high interest rates. This is not a happy situation. Eventually something's going to give.
Proponents of a Bernanke rate intervention, to accompany the $24 billion liquidity injection, argue that inaction will lead to recession (or as I see it, a necessary readjustment). Fortunately for the developed world, the painful brunt of an international downturn will be felt by the developing an underdeveloped nations of the world. When potential investors tighten up, they look for reliable, established places to put their money. As far as equity markets go, the US is the paragon of that stability. Latin America, Eastern Europe, Southeast Asia, China, and Korea will be in for a rougher ride than the US, Western Europe, and Japan will be.