The Federal Reserve, reacting to concerns about the subprime lending crisis that’s rocked financial markets in recent weeks, Friday cut its so-called discount rate half a percentage point, to 5.75 percent.
The discount rate is distinct from the funds rate, the latter directly influencing adjustable and new mortgage, credit card, and auto loan rates. But cutting the discount rate by 8% provides a cheaper source of cash for banks and lenders who are reeling from the subprime meltdown. Keeping the marginal lenders afloat now kicks the can down the road, making the inevitable that much more painful.
It’s similar to the federal $15 billion bailout of the airline industry in late 2001. Too many carriers remain today, with optimal economies of scale being difficult to attain. This bleeds into customer service and raises questions about every airlines’ long-term financial stability. At least in that case, though, there was reason to be sympathetic toward the carriers.
The immediate nature of this fix is fitting, really. To ameliorate a problem that arose from a short-term focus on granting as many loans as possible as quickly as possible, the Fed uses a short-term ‘solution’. While it’s being billed as symbolic, it has substance. It’s precursory, as it indicates the Fed will almost certainly raise the funds rate in September.
The economically marginalized are most hurt by these subprime loans, as they tend to be disproportionally oriented for the short-term. I want the three bedrooms now, even if the stars must align to make the minimum on the house, the car, and the three credit cards! Instead of defaulting, going under, and being forced (due to bad credit) to live within their means, the Fed is saying “Let them dangle on the edge of the cliff a little longer while we help out the profligate lenders.”
Hopefully Bernanke, who must have felt forced into lowering the discount rate (he’s a fan of government-provided liquidity, but is hesitant to pull the trigger on interest rate cuts), will strike out at the shrouded status of Freddie Mac and Fannie Mae which, while not backed by explicit government guarantees, are considered necessary by the government to buoy the amount of cash available for new loans. With this excess paper money floating around, banks and their S&Ls feel competitively obligated to accept less of a risk premium on the loans they make. That liberality, made worse by the mandating of “equal housing lenders” in 1988, has brought this all to a head.
Boiled down to its essentials, lenders are making overly risky loans without an adequate required return because they 1) Feel they can count on government intervention like the liquidity injections that have taken place over the last week and now the hasty discount rate cut, 2) Are able to sell their loans to Freddie and Fannie so they can use the cash to make more loans, and 3) Feel pressured into making questionable loans, less they face the wrath of FHEO, even when demographic/lifestyle data of potential borrowers causes them to hesitate.
This skews private lending in the US toward perpetual easy money. The precipitous market declines are going to get worse in the coming months. Bandaids like the discount cut only treat the symptoms. We need to overhaul the sickly body to prevent this from happening again.