Kass: 'Don't Fight the Fed.' How Quaint

Today, we face an economy that has far less promise with participants (consumers, hedge funds and borrowers of all kinds and shapes) all hocked up. Unlike 1998, today's housing market is in a sustained downturn, which will not likely recover until 2010. The consumer is at a tipping point, hedge funds don't hedge, and the world's economy faces a broad credit crunch. What was a liquidity issue seven years ago is both a liquidity and solvency issue today.

I have argued that, in the current credit cycle, nontraditional lenders have proliferated by circumventing Regulation T and banking reserve requirements, serving to soften or even dull the Fed's role in monetary policy. In turn, this systemic change has led to unusual borrowing in the form of interest-only and teaser adjustable-rate mortgage loans and levered quant hedge funds.

Furthermore, growth in the derivative market ran amok, serving to underwrite the sale of a broad-based group of products (such as motorcycles, automobiles, furniture, etc.) and also serving to brighten the markets for private equity .

This added liquidity from nontraditional lenders also buoyed the credit market, allowing companies that should have failed to tap large sums of equity and bonds. This created the feeling that all was well with the business world as stock markets rallied around the globe and corporate default rates hit all-time lows in 2006.

But this was an illusion.

With credit being extended to everyone, the consumer -- already having ponied up to the Credit Bar Saloon -- went further into hock by loading up on ARMs and "no-money-down" durable (and nondurable) purchases. The hedge funds, in this period of mispricing of risk, got into the act by levering up in order to capture unsustainable returns. (According to Merrill Lynch (MER Quote), hedge fund assets now approach $10 trillion, which is supported by less than $1.5 trillion of equity.)

The "hot money" provided by nontraditional lenders eventually led to what we have today and what I have described as a tightly wound financial system vulnerable to any interruption or negative event. The subprime mess was the event that triggered a chain reaction and a reassessment and repricing of risk; it was a ticking credit time bomb that most ignored -- until recently.

Pushing on a String

Pushing on a string means that the positive impact of lower interest rates is overwhelmed by the reduction in credit availability and the desire to borrow, as lenders try to improve the quality of their loan book and repair their balance sheets.

The 50-basis-point reduction in the discount rate will likely be followed by further easing by the Fed, but it will do little good

The combination of stressed and stretched individual mortgage holders, a consumer levered far greater than in 1998, crippled nontraditional lenders, grossly extended hedge funds and debt-heavy subprime companies will exacerbate the downturn in the domestic economy in a far more severe manner than during the LTCM crisis. The two periods, quite frankly, are not even comparable in terms of how secure or shaky the economic foundation is.