The Fed's action had two immediate benefits:
- It restored investor confidence and let Wall Street know that the Fed was willing to act to ensure proper functioning of financial markets and prevent damage to the economy
- It provided another shot of liquidity in addition to the billions of dollars that the Fed had already provided through a series of repos
My worry is that the root cause of the market's problems has not been addressed. That root cause includes the sub-prime mess but is not limited to sub-prime. There has been a period where risk has been virtually ignored in all kinds of lending. We are seeing the worst of it in real estate but there are also many examples to be found in the financing for leveraged buy-outs, for example. Witness the proliferation of "covenant-lite" debt that has found its way into hedge fund and bank portfolios.
In this kind of situation, those investors who typically can be relied upon to buy the debt being offered from these various kinds of deals are now insisting on either higher risk premiums or tighter terms and conditions. This has analysts declaring a "credit crunch" is taking place. Some might simply call it prudent lending.
Two Questions --
- Will the Fed's increase in liquidity convince investors to go back to taking on risky, low-quality debt? Probably not.
- Will the Fed's increase in liquidity prevent low quality debt instruments like bonds based on sub-prime loans from losing value and causing investor losses? Again, the answer is no.
I think investors will enjoy the Fed's liquidity move for another session or two and then begin to worry about the undiscovered debt bombs that are still out there. This will take the wind out of the market's sails and stall the recovery for a while.
A period of time with no bad news about hedge funds imploding or lenders going belly up is what is needed to restore investor confidence in the long-term ability for stocks to resume the bull market. Hopefully, we won't have to wait too long.