Why is the cautious chairman of the Federal Reserve, Alan Greenspan, suddenly reducing interest rates?
For one answer, look to Scott Grannis, whose investment-management firm handles $47 billion in assets. About a year ago, seeing rising economic risks, he became more selective about making loans. "There were people we weren't willing to lend to," says Mr. Grannis, director of Western Asset Management Co., in Pasadena, Calif.
In recent months, as the news filled with stories of Russian government defaults, problems in Brazil, and hedge-fund bailouts, other lenders took the same view as Grannis.
As a result, many banks, real estate tycoons, entrepreneurs, and corporations that wanted credit suddenly found themselves paying a lot more interest - if they could even borrow the money. On Wall Street, traders talked about a "credit crunch."
Mr. Greenspan knew the Fed had to boost the availability of money, so last Thursday he dropped interest rates one-quarter of a percent - only two weeks after a similar action.
Greenspan's move - and the prospect of more rate cuts to come - helped lift the stock market. Indeed, by Friday, the Dow Jones Industrial Average posted its best week in history, soaring 517.24 points.
The rate cut is an effort to reestablish lenders' confidence. Without access to affordable loans, analysts warn, businesses and consumers will curtail their spending and plans for expansion - factors that could slow economic growth or even contribute to a recession.
Greenspan is hoping investment managers such as Grannis, as well as the banking community, will now start to make more loans again. "The danger is over,... the problem now is that people are retrenching," says John Burgess, a managing director at Bankers Trust Co.
To an extent, the Fed's policy is starting to work, say money managers. For example, Alliance Capital Management, which runs $260 billion in assets, says it is looking to start buying stocks again in more credit-sensitive areas, such as banks and financial institutions. "We're dipping our toe back in," says Lawrence Kreicher, chief economist.
Mr. Kreicher expects the Fed will reduce rates by a full percentage point over the longer term. "The message from Thursday was that we don't need to wait till mid-November to move again. It's not a question of if, just a question of when."
Most money managers and economists expect the Fed will move again in mid-November and in December, when its Open Market Committee meets. Additional cuts are needed because some lenders still lack confidence, says Sung Won Sohn, chief economist at Norwest Corp. in Minneapolis. "This [latest] interest-rate change will not change the confidence," he says.
Lenders remain uneasy for a variety of reasons. For example, it's still not clear what will happen in Brazil. The Fed's interest-rate reduction temporarily relieved some pressure on the Latin giant. But Brazil still needs to borrow $30 billion to $40 billion next year. "The question is, if you are a foreign investor would you like to buy a Brazilian bond?" asks Mr. Sohn.
A healthy Brazil is important because the US sends 18 percent of its exports to Latin Americans countries. "They are one of our largest customers," says Sohn. Moreover, American corporations and banks have $75 billion invested in Latin America, almost a third of that in Brazil.
This is not the first time lenders have clammed up. The last significant crunch was in the 1980s, with the savings-and-loan crisis. It took years for the government to clean up the loans from that era.
This time, the banks find themselves in a bind over their loans to Russia, which has defaulted on about $20 billion in debt. "What makes this different from the [S&L] crisis is that it is much broader - almost every major bank has a position in Russia," says Mr. Burgess.
In addition, the banks' risks were increased when they loaned money to hedge funds - speculative investment vehicles that mainly cater to the wealthy. One of those is Greenwich, Conn.-based Long Term Capital Management, which required a $3.5 billion bailout from its lenders. Long Term Capital had also invested in Russian bonds.
The hedge-fund problems spilled over to the mortgage markets, where the speculative and secret groups had made bets on interest rates. However, the value of their investments in mortgage-backed securities declined as investors, concerned about the Asian and Russian crises, fled to the safety of US Treasury bills.
"When things went bad, there was kind of a snowball effect, and they [hedge funds] had to sell securities," says Ken Boertzel, a portfolio manager at New York Life Asset Management, which has about $20 billion in assets.
THIS flight to quality among investors has spread to the banking and corporate sectors. The junk-bond market for lesser quality companies has dried up. Last week some money center banks - which include the big lending institutions of New York - had to scramble to fund their overnight cash needs.
Bond traders say the Fed's move on Thursday did not change this aspect of the markets. "Credit is just not available," says Grannis. "No one wants to lend."
With the credit markets still tight, it's likely the Fed will lower interest rates further. Fortunately for the Fed, there are no signs of inflation. The government reported Friday that the Consumer Price Index was unchanged in September.
"The best strategy is to ease the worries with lower short-term rates," says Roger Kubarych of Kaufman & Kubarych Advisers LLC, which manages about $500 million in the bond market.