Liquidity Now!
The time has come for the Federal Reserve to cut the federal funds interest rate substantially, starting on a path from the current 5.25% to 4.25% and possibly even less. Without such a policy shift, the U.S. economy faces the risk of a significant economic downturn.</br></br>Three separate but related forces are now threatening economic activity: a credit market crisis, a decline in house prices and home building, and a reduction in consumer spending. These developments compound the general weakening of the economy earlier in the year, marked by slowing employment growth and declining real spendable incomes.</br></br>The current credit market crisis was started by widespread defaults on subprime mortgages. Borrowers with poor credit histories and uncertain incomes had bought homes with adjustable-rate mortgages characterized by high loan-to-value ratios and very low initial "teaser" interest rates. The mortgage brokers who originated those risky loans sold them quickly to sophisticated buyers who bundled them into large pools and then sold participation in those pools to other investors, typically in the form of tranches with different estimated degrees of risk. Many of the buyers then used these to enhance yields in structured bonds or even money market funds.</br></br>Many subprime borrowers eventually had difficulty making their monthly payments, especially when teaser rates rose to market levels. The resulting defaults exceeded what investors in the mortgage pools had expected.</br></br>Credit risk in financial markets had been underpriced for years, with low credit spreads on risky bonds and inexpensive credit insurance derivatives provided by investors seeking to raise their portfolio returns. With such underpricing of risk, hedge funds and private equity firms substantially increased their leverage.