Will Rate Cuts Save America?

The Federal Reserve has cut its funds rate for the third time in 2008. But will this be enough to stave off a recession?

My Foolish colleague David Stevenson is taking an Easter break, so no apocalyptic warnings from him this week. Instead, you can sit back, relax and enjoy my equally gloomy views on the credit and stock markets... The Fed rides again On Tuesday, the Federal Reserve (the US central bank) cut its funds rate by three-quarters of a percentage point (0.75%). This takes the rate at which the Fed lends to commercial banks from 3% to 2.25%. On September 17, this rate stood at 5.25%, so the Fed has slashed it by three full percentage points in six months. For the record, here is a list of those rate cuts: DateCut (%)Newrate (%) 18/03/08 0.75 2.25 30/01/08 0.50 3.00 22/01/08 0.75 3.50 11/12/07 0.25 4.25 31/10/07 0.25 4.50 18/09/07 0.50 4.75 At 2.25%, the funds rate is the lowest it has been since 1 February 2005. Thus, dramatic rate cuts have seen it tumble to a three-year low. However, will rate cuts be enough to keep the US from lurching into recession? News of the latest rate cut certainly steadied US investors' nerves on Tuesday, as the Dow Jones Industrial Average jumped 420 points, its biggest one-day gain since 2003. Treat the cause, not the symptoms Nevertheless, the latest economic data clearly suggest that the US is slipping towards recession. On Tuesday, US Treasury Secretary Hank Paulson warned that the US economy faces a `sharp decline'. However, in common with other pundits, he forecasts a `shallow' recession and a return to growth in the second half of the year. Alas, I'm not convinced that the US will escape so easily from the credit crunch! I take the view that lowering interest rates to tackle the ongoing liquidity crisis is akin to `pushing on a piece of string'. My other analogy is to liken the Fed cutting rates to a doctor feeding painkillers to a patient in order to treat an injury. Too many analgesics and the patient could die; too few and the pain persists. What's more, the tablets treat the symptom (the pain) instead of the underlying cause (the injury). The real problem: banks need fresh capital To me, the underlying problem isn't interbank lending rates as such. I don't even place the blame on US house prices (which have dived by 9% in the past year). Instead, the biggest problem is the ongoing destruction of banks' capital and a `forced shrinkage' of lending markets yet to come. Indeed, banks on both sides of the Atlantic are stuck between a (Northern) rock and a hard place. Reckless lending in recent years has left them facing sizeable bad debts and defaults. The US housing boom has now turned into a slump, leaving banks nursing losses which run to hundreds of billions of dollars. Thus, the banking chickens have come home to roost and banks are desperately scrabbling around trying to replace this lost capital. How much capital do banks need? The bad news is that replenishing their coffers to their previous overflowing levels is a tall order for the banks. International banking standards require banks to maintain a Tier 1 capital ratio of 8%. This means that in order to lend £12.50, a bank need have only £1 of unencumbered capital. However, this level of leverage wasn't enough for go-getting banks, which released yet more capital by securitising and selling on existing loans. In the boom years, banks gear up by packaging parcels of mortgages and other loans into bonds. These are then sold on to investors such as insurance companies, pension funds and other banks. However, the huge losses on these high-yield bonds sustained by investors worldwide have caused securitisation markets to close down almost completely. Thus, banks can no longer use this channel to offload loans from their balance sheets -- a situation which could continue for months, if not years. What can banks do now? In short, banks have rashly and deliberately allowed their capital cushions to shrink too much. Without securitisation, what options are open to them? I can see four possible routes: 1. slashing dividends, in order to reduce cash flow to their shareholders;2. selling businesses and assets (while trying to avoid a fire-sale); 3. capital-raising exercises, such as rights issues, capital injections from sovereign wealth funds and other cash-rich organisations; and4. being bailed out by nation states, as happened when the government nationalised Northern Rock. Some banks have already seized the nettle by slashing dividends. For example, Citibank cut its dividend by more than two-fifths (41%) in January. This has yet to happen in the UK, although I recall Barclays cutting its dividend in 1992 during the last recession. If UK banks trim their dividends, then it will be the end of the double-digit income on offer from the shares of several major British banks. Likewise, if a leading high-street bank decides to rebuild its balance sheet by issuing new shares, then this means more pain for existing shareholders. For these reasons, I am steering clear of buying shares in UK banks for now, despite their low price-earnings ratios and high dividend yields. Although banks are desperate for new capital, predicting their future earnings has become pure guesswork. Thus, I'll let other investors go to the head of the queue for now! The worst is yet to come... With their capital bases shrinking, banks have no choice but to cut back on their lending. For example, half of all UK mortgages have vanished in the past six months, leaving even top-drawer customers struggling to borrow. Of course, the knock-on effect of reduced lending to businesses and individuals is a contraction in spending. Falling consumption leads to lower corporate profits and job losses, which drive down spending yet further. Thus, I don't believe that rate cuts are the knight in shining armour that will ride to the rescue of besieged bankers. Lower levels of lending will, inevitably, curtail economic growth until the Augean stables have been cleaned out and growth can begin anew. Until the full extent of bank losses is known and banks have been recapitalised, the future remains very uncertain. Indeed, it's quite possible that credit and stock markets still have further to fall. Hence, while pessimists have the upper hand, it would be a good idea to `hope for the best while planning for the worst'. So, make sure you have enough cash to tide you over a bad patch, lest you join the long line of casualties of the credit crunch! Further reading for doomsayers Liar's Pokerby Michael Lewis -- how securitising mortgages led to the collapse of the US savings & loan industry (alias `thrifts', the US equivalent of our building societies) Devil Take The Hindmost: A History of Financial Speculationby Edward Chancellor -- a magnificent history of financial booms and busts throughout the ages A Demon of Our Own Design: Markets, Hedge Funds, and the Perils of Financial Innovationby Dr Richard Bookstaber -- how complexity in financial markets inevitably leads to excess, over-leverage and then collapseMore: Boost your personal balance sheet with a savings account | Credit Crunch Investing | Stearns Goes Pear-Shaped. Who's Next?