Repricing risk

Although a Fed rate cut might seem like a "slam dunk" to reverse uncertainty about the economic outlook, one of the strongest reasons for the Fed not to cut its rate is that it would interfere with the process of repricing risk that is currently underway. The single largest cause of the current "mortgage mess" and other financial excesses is that risk was heavily discounted so that virtually all asset classes and categories were priced as if the risk were negligible or even nonexistant. We are now in the middle of reversing that process, which takes time, so that the rate of return of any asset or asset category will more closely approximate the risk of that asset. Even risky subprime mortgages can be priced to both adequately reflect risk and to provide an adequate return for investors, but that repricing or "haircut" does not happen overnight and not all investors have the skills and experience to do that repricing.

There are precisely two things that really need to happen to stabilize financial markets: 1) continue the repricing process until a relatively stable equilibrium is reached, and 2) avoid improper infusions of liquidity that interfere with that repricing process.

There are really four main forms of liquidity that are relevant to the current situation:

1. Liquidity in the banking system that permits transactions to be processed efficiently and economically.
2. Capital to loan to creditworthy borrowers who are financing legitimate real-world needs.
3. The flow of capital to reprice risk so that buyers of assets feel that they are acquiring sufficient liquid value that they will have little downside risk should they decide to sell.
4. Speculative capital to fund high-risk, high-profit speculative opportunities, such as hedge funds and private equity.

The Fed has done a great job of assuring liquidity in the banking system.

There appears to be a reasonable amount of capital available for financing legitimate real-world needs for creditworthy borrowers.

The risk prepricing process appears to be well underway, although it may be a number of weeks or even months before we see asset prices truly reflect even a rough approximation of true risk. The main ingredients here are sufficiently dramatic "haircuts" and increased transparency and flow of information.

The sticking point is the availability of speculative capital. On the one hand there are signs of a "crunch" or "freeze", but I believe that is mostly not a lack of capital (the pension funds accumulate tons of it every payday), but simply a "pause" as the risk repricing process stumbles along.

The key point is that the flow of speculative capital that distorts risk pricing would only increase if the Fed cuts their rate, and that would interfere with the risk repricing process. Speculative capital is needed in a growing economy, but an excess of speculative capital can be a distinct negative for even a healthy economy.

Yes, a Fed rate cut would also trigger a flow of more capital at a lower price to loan to creditworthy borrowers for non-speculative real-world needs, but I believe that would happen anyway as a side effect of the repricing of risk. One of the problems we are working through right now is a "risk backlash" where both high-risk and low-risk assets are being slammed independent of actual true risk. That backlash will incrementally fade over the coming weeks and months so that high-risk assets retain a high-risk label and lower-risk assets  revert to appropriate lower-risk labels.

The real bottom line is that only the markets can properly determine risk pricing. The Fed should not intervene to force risk pricing, but simply assure that the banking system has sufficient liquidity to handle transactions which do have proper risk pricing.

-- Jack Krupansky