Why the Subprime Mess Doesn't Require a Fed Rate Cut

Brad DeLong has capitulated. "I have been an optimist about the subprime market," he says. "Now I am not so sure. It no longer looks like things are as contained as I had thought... if I were on the FOMC I would start voting to cut interest rates."

It's not clear to me what datapoint(s) converted DeLong from optimist to pessimist. I hope it wasn't the blog entry he quotes headlined "$10 Billion Hedge Fund Now WORTHLESS", because that's just wrong. If a $1 billion fund controls $10 billion of assets which then decline in value to $9 billion, the whole $1 billion is wiped out – but that's only $1 billion of losses, not $10 billion of losses. There's still $9 billion of assets left over.

It's also interesting that DeLong has turned pessimistic even as the stock market is shrugging off the whole shebang and making new highs, and the non-RMBS parts of the credit markets seem to be quite deliberately and pretty quietly moving to a more sustainable and sensible footing. In other words, LBO debt and CLOs and the like are now being priced where they ought to be priced, rather than at the ridiculous levels we saw in the recent past. Call it a controlled deflation of the credit bubble, which might well prevent a catastrophic bubble-burst.

In such a situation, what would a rate cut achieve? It might be counterproductive, and reflate the credit bubble which is only now (finally, thankfully) subsiding. What's more, it wouldn't give subprime borrowers any more access to houses than they have already, since the limiting factor there is not interest rates but underwriting standards. Nothing that Brad worries about in terms of increased supply and decreased demand for housing would really change, especially considering the fact that the housing market, more than any other, is based on long-term rates in the 15-30 year range, which have shown no inclination whatsoever to react to changes at the overnight end of the curve.

I do think that regulators might want to have a close look at the foreclosure process if and when it starts affecting many more people than it ever has in the past. But cutting interest rates to help out overindebted homeowners is not going to help.