Why the Fed's rate cuts won't help you

Fed outwitted and outplayed

To be fair, the Federal Reserve never wanted to be in this position, and it told Congress as recently as a few months ago that the U.S. economy was in such great shape that it had no intention of lowering interest rates in a material way anytime soon. But the Fed's leaders, a dangerous mix of university professors and career bureaucrats, were drawn into a trap at amazing speed by dark forces in the global financing system that they now admit they scarcely understood.

How could this happen? Albert Wojnilower, who was chief economist at Credit Suisse First Boston for a quarter of a century, observes that the history of finance is rife with examples of financiers who successfully outwit their referees -- the accountants, auditors, rating agencies, bank examiners and government agencies that are assigned to create and enforce rules.

Wojnilower, now an adviser to Craig Drill Capital in New York, points out that just as in sports, some of these officials may be corrupt, indifferent, incompetent, or even hostile to the rules themselves, but they always fall behind the financiers. He notes that as soon as lenders are freed of constraints -- as they were in this case by Bush administration officials eager to deregulate the industry -- they are spurred by huge short-term rewards "to compete addictively with one another in taking bigger and bigger risks.” Wojnilower says that eventually havoc breaks loose, forcing responsible government authorities to halt the chaos by providing bailouts to participants considered too big to fail.

It's a bit ironic, and not a little sad, that government has come to believe it has to fight fire with fire. The Fed, whose leaders are appointed by the president, is essentially trying to battle problems created in an era of overly cheap money and loose lending by making money even cheaper and lending even more aggressively.

In just the past few weeks, it has broken all of its own rules by providing hundreds of billions of taxpayer funds to brokerages at special auctions, opening a bigger "discount" window to permit a wider range of financial institutions to beg at the government till and accepting weaker-than-normal collateral such as iffy mortgage-backed securities. The Fed has put the government in the position of being the payday lender of last resort.

The Fed's hamster wheel

Just to top it all off, the Fed this week announced plans to allow the twin titans of government-supported mortgage finance, Fannie Mae (FNM, news, msgs) and Freddie Mac (FRE, news, msgs) -- which have proved themselves horrible at managing risk -- to make even bigger loans than they had previously. And it is telling banks to let individuals facing foreclosure to stretch out their payments a little longer.

It is all a bit crazy, which is why many veteran financial advisers recommend that investors remain skeptical of rallies.

The market rallied before today's Fed action, expecting a full percentage-point cut, and reacted well initially even to the less aggressive action. But what you want to watch is the reaction of debt markets, not the equity markets. Credit investors, who are the real masters of the global economic system, believe that the Fed is like a hamster in a cage that has to run faster just to stay in place as events spin faster and faster out of its control.

To have had a chance at getting ahead, by making money so cheap that lenders would have abandoned their policy of distrust toward borrowers, the Fed should have cut rates by 1.25 percentage points today. As the Fed's effort fell short, the hamster will likely just go back on the wheel.

At the time of publication, Jon Markman did not own or control shares of companies mentioned in this column.

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