The Fed buys some time to rebuild confidence

By TOM PETRUNO

Aug. 18, 2007 12 AM PT

Confidence went out the window on Wall Street this week, and that’s why the Federal Reserve had to cut one of its key interest rates Friday.

However else the decision was dressed up -- Fed supporters say policymakers intervened to protect the economy, while critics say the central bank is simply bailing out major financial companies -- this ultimately was about confidence.

Without it, we don’t have a financial system. And if the system goes, it almost certainly would take the modern global economy with it.

So the stakes are astoundingly high. And let’s note right off, there is no guarantee that the Fed’s sudden policy shift will have the desired effect, which is to keep credit flowing.

Indeed, for their own health, many big investors and lenders should stay focused on pulling back from the orgy of borrowing that got the financial system into its current mess. That is why stock and credit markets are likely to remain cautious, despite the 233-point surge in the Dow Jones industrial average Friday.

Still, “at the very least this buys some time,” said Doug Peta, market strategist at money manager J&W; Seligman & Co. in New York.

In a move announced before markets opened, the cost for commercial banks to borrow directly from the Fed was dropped to 5.75% from 6.25%. And the central bank encouraged institutions to use its borrowing window.

The Fed’s action was less significant than a cut in its so-called federal funds rate, which has been at 5.25% since June 2006. Had the Fed lowered that rate banks most likely would have pared the prime lending rate, now 8.25%, by the same amount.

Nonetheless, policymakers soothed battered markets by feeling their pain: “Financial market conditions have deteriorated, and tighter credit conditions and increased uncertainty have the potential to restrain economic growth going forward,” the Fed said.

As most everyone knows by now, what began early this year as a problem of surging mortgage defaults -- a byproduct of the wretchedly excessive housing boom -- has since spread far and wide. Stunned by mounting losses on mortgage-backed bonds, many lenders and investors have done a complete 180-degree turn, and have looked for excuses to cut off credit, or make it much more expensive, for all sorts of borrowers besides the lowest rung of mortgage applicants.

The stock market has suffered collateral damage, but equities aren’t the issue here. At their lows Thursday before buyers flooded in, most major U.S. stock indexes were down not much more than 10% from their recent peaks. To put it in historical context, that’s nothing more than a garden-variety “correction” in a bull market.

The real crisis of confidence has been in the bond markets and, increasingly, in the banking system. When mortgage loans of even the highest-quality borrowers can’t find buyers on Wall Street; when worried depositors line up at the banking offices of home loan giant Countrywide Financial Corp. to pull their money out; when shareholders of money market mutual funds start calling their fund companies to ask about the safety of the short-term corporate IOUs the funds own -- that’s a confidence problem the Fed can’t ignore.

Policymakers had some cover Friday, whether they knew it was coming or not: The monthly Reuters/University of Michigan consumer confidence survey showed a drop in the main confidence index to a one-year low of 83.3 this month from 90.4 in July. That suggests the turmoil in financial markets is having an effect on peoples’ perceptions of the real economy.

To the Fed’s detractors, Friday’s rate cut -- and the hint of more to come -- is a de facto bailout of financial companies and investors.

We’ve seen this movie before: The Fed eased credit after the stock market crash of October 1987; in September 1998, when the huge hedge fund Long-Term Capital Management was collapsing; and after the Sept. 11, 2001 terrorist attacks, when global markets dived.

By trying to make credit more available, the Fed may indeed save some big investors that took outsized risks and should be allowed to fail.

That’s the “moral hazard” issue: Every time the Fed rides to the rescue, it may lower investors’ sensitivity to risk-taking. If you figure you’re going to be bailed out, why bother being diligent in assessing the risk of competing investments? Just go for the biggest potential return, which almost certainly will carry with it the highest risk.

Hedge funds and other investors that bought ridiculously complex mortgage securities in 2006 did so because the promised returns were so appealing. How could they believe that the risks were low? Investing lesson No. 1: There is no free lunch.

Taken to its extreme, the argument against Fed intervention in the midst of a genuine financial-market crisis is an argument for taking a chance that the economy will be dragged needlessly into recession, or worse.

“This is not all about ‘Wall Street,’ ” says David Rosenberg, an economist at Merrill Lynch & Co.

“Most of the lenders and home builders going under are regional in nature -- not New York-based.”

What’s more, Rosenberg and other analysts say, the unwinding of this decade’s debt boom is well underway, and a few Fed rate cuts won’t stop that process. The pendulum always swings back, and in either direction it tends to go too far.

The Fed has stepped in to give lenders, borrowers and investors some breathing room -- a chance, perhaps, to be much more rational about their financial decisions than they would if the gears of the system were on the verge of locking up, threatening consequences too dire to contemplate.

tom.petruno@latimes.com

(BEGIN TEXT OF INFOBOX)

MONDAY

Dow close: 13,236.53

-3.01

Goldman Sachs says it will prop up a faltering hedge fund with $3 billion in cash.

A Canadian issuer of short-term IOUs has trouble selling debt.

TUESDAY

Close: 13,028.92

-207.61

Mortgage giant Countrywide Financial says foreclosures hit a five-year high.

Wal-Mart says many of its customers are struggling financially.