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The Fed's Next Move: A Wall Street Bailout?

Lending meltdown may force Fed to cut interest rates

by Martin H. Bosworth
ConsumerAffairs.com

August 19, 2007

The Federal Reserve voted on Friday to cut the "discount lending rate" between regional Fed offices and banks from 6.25 percent to 5.75 percent. The Fed also voted to extend the "loan term window" of emergency loans from one day to 30 days.

The Fed issued a statement alongside the change, noting that "[f]inancial market conditions have deteriorated, and tighter credit conditions and increased uncertainty have the potential to restrain economic growth going forward."

"The Committee is monitoring the situation and is prepared to act as needed to mitigate the adverse effects on the economy arising from the disruptions in financial markets," the Fed said in its statement.

Although the Fed has voted to maintain interest rates at their current level for many months, the discount rate change was widely interpreted as a precursor to the Fed's plan to cut interest rates in order to spur more lending and credit usage.

It was extremely low interest rates, coupled with a massive boost in home prices and usage of home equity for spending, that propelled the country's economic growth for the last several years. Now, with home prices falling, gas prices staying high, and consumers already maxed out on debt, cutting interest rates would largely lead to more of the same behavior--and the same consequences.

"The Sky Isn't Falling"

Federal Reserve governors such as William Poole, president of the Federal Reserve Bank of St. Louis, have said that a rate cut would be unnecessary barring a "calamity."

"No one has called up and said the sky is falling," Poole told Bloomberg News on August 15.

Federal Reserve chairman Ben Bernanke has also publicly opposed lowering interest rates or any sort of larger bailout for financiers caught up in the subprime and credit meltdown.

Political columnist Robert Novak claimed in his Washington Post column that the Fed was indeed moving towards an interest rate cut, but elected to hold off so as not to appear to be supporting the bailout of multimillion-dollar hedge funds like Bear Stearns.

Several of Bear Stearns' hedge funds have collapsed after concentrating heavy investment in subprime mortgage loans, and other hedge funds--and the lenders they invest in--are hanging on only through layoffs, spending cuts, and continual infusions of cash from global money reserves.

Lenders such as New Century Financial and American Home Mortgage are declaring bankruptcy and exiting the mortgage business en masse, leaving the markets in turmoil and homeowners at a loss as to how to protect their investments.

Countrywide's Bad Run

The Fed also may be reassessing its tactics in light of the massive money withdrawals from Countrywide Financial, one of the nation's biggest mortgage lenders.

After financial analysts claimed Countrywide might seek bankruptcy protection due to failure to meet its loan obligation, the bank borrrowed $11.5 billion in funding from credit lines offered by other banks. The move spooked investors even more, leading to the one-day bank run.

Countrywide was heavily invested in subprime loans with higher interest rates, which are often specifically targeted at borrowers with little or no credit, particularly women and minorities.

Countrywide settled a probe into its lending practices in 2006 by former New York state Attorney General Elliot Spitzer. The Spitzer investigation found that even with individual factors like credit scores and loan histories, black and Latino borrowers paid more for their loans than white customers.

With giant players like Countrywide on the verge of collapse due to heavy concentration in bad loans, the focus will be on the Fed to decide what's more important -- spurring even more lending with historically-low interest rates, or buckling down and letting greedy hedge funds and brokers suffer the consequences of the credit crunch.

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