What to Expect From the Fed on Interest Rates This Week

Not since the days of the Enron collapse have the banks received so much publicity in print and electronic media. The only thing banks may like about all the attention this time is that it comes free of charge.

What started the credit market problem was the collapse in the U.S. housing sector. This exposed the irresponsible and outright stupid practices in subprime mortgages that were packaged by financial institutions and re-sold as investment-grade securities to investors. This created a spectrum of esoteric debt derivatives developed and sold by the wizards of Wall Street and Bay Street to investors hungrily looking for extra yield on their holdings.

An underlying cause for the current mess in the credit market was the financial contraptions based on issuing short-term debt and investing the borrowed funds in higher-yielding, longer-term securities. This is not the first nor probably the last time that borrowing short-term and investing long-term has eventually backfired.

In past instances, this play on an interest spread came to a halt when the Federal Reserve temporarily pushed short-term interest rates above long-term maturities. What was fatally different this time was the sudden collapse in short-term commercial paper, which made it impossible for financial institutions to refinance (roll over) their maturing short-term borrowings.

The latest financial derivatives that have exploded are something called structured investment vehicles (SIVs). The estimated face value of these now crashed vehicles runs anywhere from $350 billion to $400 billion. They have typically been set up by large banks eager to earn fees and harvest the yield spread between short-term and long-term maturities.

While the plight of the overextended homeowners received only verbal “help” from the government, banks facing an SIV meltdown have the U.S. Treasury riding to their rescue. Interestingly, it is the Treasury rather than the Fed that is organizing an $80.0-billion super-fund. The super-fund, created by Citigroup, Bank of American and JP Morgan, is expected to process the financial waste held by SIVs into something that can be marketable again without banks being forced to mark down holdings in SIVs to their current market values.

Though the Treasury has assumed the role of the U.S. Cavalry, the Fed is expected to do its part by slashing the discount and federal fund rates again during the upcoming October 30 & 31 FOMC meetings. The September 18 cuts in interest rate by the Fed helped to calm the credit markets and provided much needed relief to the stock market. The less desirable side effects, blissfully ignored by bond and equity investors, have been a further slide in the U.S. dollar accompanied by still higher prices in oil and gold prices.

There is now a prevailing anticipation of the same market reaction to the next cut in interest rates during the upcoming FOMC meeting. Investors’ conviction that interest-rate cuts will always be effective in rescuing the market from any financial abyss is presently the life support of this geriatric bull market.