Rogue and the Pogue

Here is why this move (as well as the next two rate cuts) will fail - the problem with world markets today is not liquidity, but capital. The difference goes beyond nomenclature - while liquidity is long form for money flows, capital is the ability of banks to sustain the losses from such lending. For example, if you make a billion dollars of loans to individuals and expect to lose about 1%, you would set aside double that, say $20 million, as "capital", and then calculate your return on those $1 billion in loans as a proportion to the capital deployed.

The problem that arose last year is that most banks seriously underestimated the risk of losses on a very larger part of their portfolio, and hence found themselves seriously short of capital required (additionally, absorbing the losses reduced their capital further). When banks don't know how risky their assets really are, it stands to reason they view their own capital adequacy suspect, and by the same measure do not trust the capital adequacy of other banks either.

For capital to flow, markets need to have appropriate risk-adjusted returns. In turn, this means everyone needs to understand benchmark pricing once again, as in the cost of transacting interbank. This problem, which increased in the middle of last year and seemed to subside this year, has returned with the Societe Generale announcement, as banks once again do not trust each other. Until all banks are convinced that their counterparts do not have nasty surprises in store, lending will remain lumpy. And as long as banks don't trust each other, they won't trust anyone else either: which is why they are unlikely to lend money to companies and individuals unless they meet previously agreed deal terms.

And the key here is that BANKS DON'T TRUST EACH OTHER.

If you don't know it, there is a crisis in the financial markets that rate cuts simply can't fix. I continue to read posts here on Free Republic that assume that rate cuts will stimulate growth. This is false. Lenders with high losses have higher reserve requirements than they expected to. Reduced transparency has lenders very nervous about loaning money unless they are absolutely, positively guaranteed to get a return on their investments.

This crisis is NOT about the cost of borrowing money, and driving down interest rates isn't going to MAKE lenders continue to make high-risk loans to people with bad credit. Many ARMS are scheduled to reset. Many people with good credit and sufficient home equity have already refinanced. Those people who are way upside-down on their home loans are not going to be able to refinance because lenders are not going to take a chance on losing money to these people who may toss them the keys anyway.

This crisis is NOT about the cost of borrowing, but about liquidity, insolvency, fear and lack of transparency.

"Many people with good credit and sufficient home equity have already refinanced. Those people who are way upside-down on their home loans are not going to be able to refinance because lenders are not going to take a chance on losing money to these people who may toss them the keys anyway."

The article posted misses the point as you correctly point out. The author is of course correct that the problem right now is not a lack of liquidity, but he fails to see that the Fed may have another purpose for its cuts this time.

I agree with most of your analysis. But here is where we disagree:

Many people with good credit and sufficient home equity have already refinanced.

And this may be the point of the rate cuts. The Fed is providing an irresistible opportunity for all credit worthy borrowers in adjustable rate mortgages to refinance. The strict lending standards now in place (as you also point out) should prevent a re-inflation of the bubble. So once this refinance wave is spent we can pretty much assume that the remaining borrowers in suspect loans are irretrievably lost and the system can flush them.

This is a pretty clever trick to try and unwind the bad mortgage debt in an optimal way. If this hypothesis is correct look for the drop in rates to be steep but of limited duration.

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