Over the last 20 years, first under Alan Greenspan and then Ben Bernanke, the Federal Reserve has taught Wall Street to expect a reward for bad behavior.
- Build a hedge fund on a mathematical model and a prayer, as Long-Term Capital Management did -- borrowing $129 billion on just $4.7 billion in assets -- and the Federal Reserve will organize a bailout.
- Bid dot-com stocks to the sky -- as Wall Street analysts did with ever-higher target prices on and others -- and the Federal Reserve will cut interest rates to 1% and keep them there.
- Put the money from that rescue to work to build skyscrapers of structured debt -- until a collapse in the market for mortgages turns even low-risk AAA-rated debt spiraling to junk bond prices -- and the Federal Reserve will cut interest rates.
Bernanke's Fed first cut rates in a panic by a half a percentage point in September, but the latest cut -- a quarter-point on Oct. 31 -- was in direct response to Wall Street bullying.
As any sixth-grade bully knows, though, if you squeeze too hard, one day the victim will turn and refuse to cough up his lunch money. Even the Federal Reserve chairman could discover a backbone one day. My bet would be shortly after the November 2008 election. If that happens, Wall Street would go into shock -- and then, watch out below.
Data offered coverBernanke had a real option on Oct. 31. Just that morning, the Department of Commerce had announced that the economy grew at a 3.9% rate in the third quarter. (The Fed sees numbers like this before their public release.) That was way above the expected 3.3% growth rate and certainly enough to give pause to anyone thinking that the economy was about to slip into recession.
Those numbers gave the Federal Reserve plenty of cover to say that it had cut interest rates by half a percentage point in September and would wait and see what effect that had. At 3.9%, the economy clearly grew at a rate above the Fed's 3% growth target for fighting inflation.
So why did the Federal Reserve instead cut interest rates, further damaging the inflation-fighting credentials of the Bernanke Fed? As best as I can figure out, the Fed didn't stand pat on interest rates because Wall Street -- by odds of 4-to-1 -- had decided that the Fed would cut rates. And the Fed decided that the financial markets were so fragile that dashing those expectations would make a bad situation worse.
Giving Wall Street its wayIf that's what the Federal Reserve was thinking, it's rubbish. It's not that the debt markets are back to normal, because they aren't. And it's not that there aren't more hedge funds and structured investment vehicles on the edge of imploding, because there are. And it's not that Wall Street -- from mortgage bank to investment bank -- isn't hoping to avoid writing off billions in illiquid debt, because it is.
But the idea that the financial markets would implode if Wall Street didn't get what it hoped for is wrong on three counts:
- An interest-rate cut of a quarter of a percentage point isn't large enough to really do anything. It won't save overextended homeowners from going into default on mortgages, and it won't make reluctant buyers of asset-backed commercial paper return to the market. These institutional buyers aren't buying because they don't trust prices, not because the interest-rate spread they can earn is too low.
- How big a sell-off did the Fed think it might trigger anyway? A 362-point drop on the ? That's just what we got on Nov. 1 anyway, as Wall Street decided to pout because the Fed's cut wasn't bigger. By the way, these days a 362-point drop is just 2.6%. The 508-point crash of Oct. 19, 1987, took that market down 22.6%. Because the Dow is so much higher now, that crash would be just a 3.6% decline.
- Market corrections are supposed to remind investors to pay attention to risk. They're supposed to make us cautious. By punishing excessive risk-taking (and just plain stupidity), the occasional correction burns off some of the fuel that would feed a much bigger market conflagration.