Quote from capmac:
The first reaction to the big European Central Bank injection of liquidity early last week, was that "they must see something that we don't." That reaction has been echoed again and again as central banks have made huge injections of liquidity. One columnist speculated yesterday, after the Fed cut the discount rate, that there must be a huge market player on the brink.
The monster is, rather, THE NEARLY IDENTICAL MATHEMATICAL MODEL used by a large number of "quant" (quantitative model) hedge funds. One assumption built into that widely shared model has been the stablility, and high liquidity, of mortage-backed paper. The fact so many funds have employed this assumption, and that this assumption has been proven to be deeply flawed, raises the specter of domino-like liquidation of fund after fund, with sell-off after sell-off in the stock markets.
The reason the Fed is relatively powerless, and therefore afraid and anxious to act early, is that NO AMOUNT OF LIQUIDITY will make market players willing to touch many billions of dollars in mortgage paper, when there is absolutely no way to value that paper! (The reason there is no way to value it, is because there is no way to predict the mortgage default rate, except that it will continue to escalate very sharply over the next 18 months.)
The Fed can cause as many one-day rallies as it likes. But every time it cuts some interest rate, it will increase the pressure on the dollar, foreign investors will sell treasuries, and MORE PRESSURE on the secondary mortgage market will result.
Incredible, unprecedented lending practices have created a monster. The herd of straight-line mortgage lenders and builders who jumped nose-deep into the game, is about to be thinned significantly. There is very, very little the Fed can do about it.
