Stock Strategist
Probably not. That is not to say that the Fed's actions will have no effect. We think they are--and will continue to be--very powerful. But we doubt that the Fed can single-handedly fix the credit crunch. (Click to watch our related video report on the Fed.)
The Root Problems
What is the Fed trying to fix? The biggest issue now is liquidity in the mortgage debt markets. Investors are shunning securities exposed to mortgages that could default. To fix that, investors need to be convinced that massive mortgage defaults will not happen, and those that do happen will be contained.
Investors fear defaults, particularly on subprime mortgages, because many borrowers took out mortgages that they couldn't afford to pay after the initial low teaser rates lapsed. Morningstar estimates that the average subprime borrower with a $200,000 mortgage will end up paying $500 more per month on his mortgage once rates fully reset to higher levels, between 2009 and 2011. Some borrowers will be able to afford this; some won't. The question remains of how many borrowers fit into each category.
Other homeowners used their homes as credit cards, borrowing home equity lines of credit (HELOCs). Investors are also worried that borrowers will not pay on these loans if the value of their property falls. They also worry that borrowers will not pay on other types of loans, including those with high loan-to-value ratios (a $95,0000 loan on a house worth $100,000 has a 95% loan-to-value ratio, which is high).
Because of all these worries, many investors have sold mortgage-related securities, and others are not buying. The market for the securities is not very liquid. This has led to the current liquidity crisis, which could lead to a full-blown credit crisis as more and more lenders refuse to offer mortgages due to liquidity and default risks.
The Fix
Fixing this mess is much easier said than done. If the Fed could get home prices to appreciate across the nation, the liquidity crisis might find an easy end. But the Fed has no power to do this. Home prices will be dictated mainly by the supply of homes in the market, in combination with the cost of financing a home (mortgage interest rate and availability of loans) and employment levels. The Fed has no control over the supply of homes. Eric Landry, Morningstar's homebuilding analyst, estimates that the U.S. now has 1 million more homes than it can absorb. That will take time to correct. And if subprime borrowers lose their houses, this number could easily double.
The Fed has some influence on mortgage rates, though less than it would like. Mortgage interest rates have historically been influenced by the fed-funds rate, which is a short-term lending rate. However, this influence is waning and may be gone altogether. Former Fed Chairman Alan Greenspan argued Wednesday in a Wall Street Journal editorial that the Fed's ability to affect long-term rates is ebbing.
In retrospect, global economic forces, which have been building for decades, appear to have gained effective control of the pricing of longer debt maturities. Simple correlations between short- and long-term interest rates in the U.S. remain significant, but have been declining for over a half-century. Asset prices more generally are gradually being decoupled from short-term interest rates. ... More generally, global forces, combined with lower international trade barriers, have diminished the scope of national governments to affect the paths of their economies.*
In a similar vein, the Fed can attempt to change another key rate, LIBOR (the London Interbank Offered Rate), which is tied to many loan interest rates. Most notably, LIBOR affects the interest rate on adjustable-rate mortgages. So the Fed would like to keep LIBOR low. Normally, LIBOR is just slightly above the Fed's target interest rate. But in the latter half of November, one-month LIBOR climbed to 5.25%. The Fed cut its target funds rate on Tuesday to 4.25%, but LIBOR remained high. In an attempt to influence LIBOR, and jump-start the economy in general, the Fed announced a plan on Wednesday to lend money to banks. $40 billion in special loans will be made available at rates below the discount rate (the rate at which the Fed normally lends to banks) of 4.75%. The Fed hopes that banks will take advantage of these loans and that the interbank loan market will become more liquid, lowering LIBOR. It also intends to help banks shore up their balance sheets by accepting a variety of collateral, including mortgage loans.
Making mortgages more available could also ease the liquidity situation. The availability of mortgages is controlled by the banks and mortgage lenders that have uniformly tightened credit standards. The Fed could have some influence on lending through the backdoor. If banks take advantage of the Fed moves and shore up their balance sheets, they may be more ready to lend to mortgage customers. However, banks may also decide to keep all the money to themselves so that their financial health is as solid as possible for their end-of-year reports and in case regulators come knocking.
Keeping unemployment low would also help strapped borrowers and the economy in general. But the Fed has only a few levers to pull here, and trying to influence all the drivers of economic health is like herding cats. The Fed may try to fix one thing, only to create another problem. With just a few blunt instruments like the fed funds rate, we believe it cannot single-handedly keep the country from going into a recession.
The Bully Pulpit
The picture that emerges from all of this shows that the Fed is one player among many, but not the primary mover in any sphere. The Fed certainly has influence, and it commands the bully pulpit. But we have yet to see whether the markets and the banks will sit up and dance when the Fed calls the tune.
Click here to read more of our ongoing coverage on the credit crunch.
* Greenspan, Alan. The Roots of the Mortgage Crisis. The Wall Street Journal. December 12, 2007, Vol. 250, no. 138, p. A19.