Since the Federal Reserve announced the highest benchmark interest rate in the last 22 years, newspapers all over the World have been flooded with skeptical headlines covering the possible next steps. Should investors be prepared for another quarter-percentage-point raise? Or is this the end of the tightening cycle? Despite the general concern, the true question to be asked is: does it really matter?
As equity markets repeatedly fail to sustain growth on their own, shareholders see themselves in search of a savior, and that is not for no reason: ever since the Great Depression took place, we have been fed the “good versus evil” narrative, a recurring cycle in which vile corporations get too greedy, fail to fulfill their obligations, generate major financial crises, and then have to be rescued by a superior entity, the Government. Contrary to popular beliefs, however, history has shown us that Central Banks were more times than not responsible for fueling or even creating the economic shocks they claim to have saved us from.
A notable example lies in the 1970s, when artificially low real interest rates spurred a surge in debt-financed investments in agriculture and oil exploration, which then collapsed as cost of capital skyrocketed just a few years later. With the sudden surge in payment defaults, more than 1,500 commercial and savings banks and a third of the Savings and Loan industry went under, a new record since the Great Depression. In spite of accumulating over 400 billion dollars worth of banking institutions in distress, the financial contagion was far less noticeable than that from 2008. So what went wrong this time?
In September 2006, the U.S. Financial Accounting Standards Board issued Statement of Financial Accounting Standards 157. Effective for fiscal periods commencing after November 2007, SFAS-157 established Mark-to-Market as the norm for most financial instruments, including the mortgage-related ones. In simpler terms, the new rule meant that assets should be valued based on the price they could be sold for immediately. Therefore, by shaking overall market confidence, bad credit and defaulting loans would now also tear down the book value of otherwise solid healthy mortgages.
Later the following year, the Federal Reserve began reducing the federal funds rate in response to worries about liquidity and confidence generated by Bear Stearns' hedge funds liquidations and the English bank run. Despite an increasing number of institutions warning clients of a possible downturn, the Dow Jones Industrial Average kept climbing until it hit a new all-time high in October 2007. When SFAS-157 came into force and MBS prices started plummeting, however, a self-reinforcing spiral of CDS default clauses was triggered, wiping out liquidity from most major banks and insurance groups.
On January 21st, after the DJIA had fallen over 15% in just a few months, Fed officials decided there was no more time to wait before further cuts in interest rates. The following day, the Federal Reserve announced the biggest reduction in over two decades, a 75 basis points lessening to 3.75%. Less than ten days later, the Open Market Committee would announce another cut, taking rates to 3% a year.
In March 2008, holding approximately thirteen trillion dollars in notional contract amounts in derivative financial instruments, Bear Stearns was facing bankruptcy. As an emergency measure, the Federal Reserve Bank of New York agreed to guarantee its subprime loans so that JPMorgan Chase would go on with the acquisition. Two days after the rescue, the F.O.M.C. reduced short-term interest rates for the sixth time in six months, lowering federal funds rates to 2.25 percent. Despite a few more reunions and aid packages in-between, interest rates and financial markets would remain mostly consistent until the third quarter.
After the Federal Reserve refused to assist Lehman Brothers as it did for Bear, however, the DJIA faced its worst decline since the Tech Bubble. The already horrific scenario would then become even worse following the Congress rejection of the 700 billion dollars Troubled Asset Relief Program, which stipulated governmental purchase of toxic assets and equity from struggling institutions. Regardless of later passing the Emergency Economic Stabilization Act of 2008, cutting interest rates to zero and creating multiple rescue funds in an attempt to provide liquidity worldwide, it was already too late to control the contagion. The American stock market was set to fall another 37% before calming down.
In March 2009, under pressure from Barney Frank, chairman of the House Financial Services Committee, the SEC and FASB agreed to produce new guidance on asset valuation, relaxing those Mark-to-Market Rules established just months before the collapse. The financial markets crisis would then finally be declared over, totalling close to twenty trillion dollars lost in household wealth.
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