Why Greenspan cut interest rates

Louis Proyect lnp3 at panix.com
Mon Oct 19 07:48:16 PDT 1998

(From Time Magazine online www.time.com)

Alan Greenspan doesn't hurry often-- at least not in front of the cameras. But a few weeks ago the paparazzi caught the cucumber-cool Fed chairman hustling across Constitution Street in Washington, dodging traffic on his way to announce the Fed's first interest-rate cut in three years. Wall Street had seen it coming, and in New York the markets yawned. But Greenspan wasn't done running. He cut rates again on Thursday without waiting for the next Fed meeting, a dramatic move that caught Wall Street off guard. It was almost unprecedented in Greenspan's term as helmsman of the U.S. economy. If the Fed has a big red panic button, this was it: Clearly Father Greenback had seen something that couldn't wait for November 15. But what?

The Fed isn't saying, exactly. But the safe bet is that Greenspan believes U.S. banks are in trouble. Big trouble. Maybe on the brink of a disaster to rival that of the S&L crisis (and subsequent government bailout) of the late 1980s. "The Fed did an internal investigation to see how much exposure the banks had to hedge funds and other high-risk investments," says TIME senior economics reporter Bernard Baumohl. "The cut was a clear signal that conditions are more severe than most of us realize."

In the '80s it was junk bonds; this time it's derivatives. Buying a derivative is taking a bet -- called an option -- on the price of a stock at some future point. The plutonium of the financial world, derivatives are complex financial instruments that, in steady economic times, can churn out megatons of money for investors. Bet badly, though, and you get a meltdown. When Long-Term Capital Management, a high-risk, high-rolling hedge fund based on the formulas of two derivatives Nobelists, went belly-up last month, Greenspan realized that the damage wasn't restricted to the brandy-and-cigars crowd. Banks and financial institutions were deep into hedge funds, and when Merrill Lynch or BankAmerica takes a $100 million hit, a lot of ordinary folks -- from bank customers to businesses to a homeowner looking to take out a second mortgage -- get contaminated. When banks lose money, a credit crunch occurs -- and that's a recipe for recession. But BankAmerica -- the nation's fifth-largest bank -- happens to have $1 billion in exposure to a hedge fund called D.E. Shaw & Co. On Wednesday, BankAmericaannounced that it had lost a whopping $370 million in its dealings with Shaw. Then it announced it was buying the fund out, which could mean even more losses while BankAmerica unwinds Shaw's apparently disastrous positions. Will there be money to loan to companies seeking to, say, hire more workers? Not likely. Greenspan's dark fear isn't just that BankAmerica took a hefty loss, it's that the bank has plenty of company.

Which is why Greenspan, no fan of government intervention, picked the spot on the food chain that's right between the banks and the people: interest rates. Then he hit the button -- twice. Thursday's quarter-point cut in the short-term interest rate, which is the rate at which the Fed lends to banks, was accompanied by an equal cut in the discount rate, the rate at which the Fed lends to banks that are waist-deep in quicksand. "It's very interesting that he cut rates at the discount window as well," says Baumohl. "Maybe he's expecting a lot of banks to be in trouble." It might be a long line.

A rate cut by the central bank gives an economy two chances to dodge the bullet. Banks can pass the savings on to their customers, emboldened by the fact that a lower-interest loan is a safer loan, or they can keep their lending rate steady, which increases the loan's profitability and helps refill a shattered bank's coffers. That in turn encourages further lending. Either way, recession is averted -- or at least softened; the U.S. may well be headed for a recession no matter what Greenspan does. "There's a limit to what Greenspan can do," says Kadlec. "He can steer the economy, but he can't save it by himself."

He can try. The Fed is widely expected to cut rates again at the November meeting, again on December 22, and quite possibly several more times in the new year. If a recession does hit, Greenspan's quick action has already given the financial-services sector some hope; bank and brokerage stocks soared some 10 percent on Thursday after the twin rate cuts were announced. That euphoria will probably prove fleeting, says Kadlec. "The financial services industry is so overbuilt, so overextended from the boom years, that there's bound to be a pullback."

Greenspan has waded into a morass of overexposure that only the banks themselves can fully gauge; if the Fed chairman sees something horrifying on the event horizon, he's not giving up the gritty details. Most market watchers trust Greenspan's near-spotless record, even if they don't know what, precisely, he sees. "Eventually he's going to be wrong, but it's too early to tell right now if this is it," says Kadlec. "I think he's acted in time."

And what about derivatives? The instruments have made a lot of people a lot of money, and Greenspan himself credits derivatives in part for the current economic boom. So will money managers break it off with the wild woman that has now brought them so much pain? No way, says Kadlec. "You never end the love affair with derivatives. Once you go down that road, you never go back," he says. "You just keep looking for new ones." See you next time, Alan.

Louis Proyect


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