The Fed has cut down the discount rate by half a percent last Friday (17 Aug). We can see it as a move of FRB (Federal Reserve Board) to allow those financial institutes in trouble to have access to liquidity without yielding to demand for a board Fed Rate cut. “The money-changers must accept some kind of haircut and should not expect bail-out” seems to be the signal of the move.

Probably as long as no major financial institutes go belly up, we can say the crisis is contained within the financial sector? But then, it is a very narrow definition of containment. Like Daniel Gross of Slate.com said, if containment of Cold War was as effective as this one, we will all be speaking Russian and farming collectively. A recession is inevitable.

NY Times has this piece of reporting on the subject. One theme in this articles is “somehow, the best brains in the Wall Street just did not see it coming”. Yeah, Ken Lay did not know anything about accounting in Enron either.

More plausible explanations are the following:

1. Of each of these well-known financial power houses, the role of research departments to traders are like the “fair and balanced” Fox news to the Republican party. Research reports from these Wall Street firms are the smoke and mirror in their proprietary trading and M&A activities. Long gone are the days when (some) researchers can write about their honest opinion. Therefore obviously the research departments said very little about the riskiness of the subprime market.
2. Traders in hedge fund and their counterparties in the financial powerhouses, who profited immensely from the paper profit from these subprime securities, simply do not have the will nor incentive to do the right thing. If the trend in the market is to buy these secularization products on leverage in order to make that outrageous return, why not follow the flow? At least one has to be in the game to show that he/she is professional. After all, it is the management fee/brokerage fee these fund managers and deal maker care about. Repercussion that may surface five years from now? It cannot be quantified as a number on P/L anyway, so no one care.
3. It is of absolutely no one’s interest to forestall a bubble. No Fed chairman or regulatory bodies will do it. When the time is good, any proactive measure will be perceived as ‘spoil the party’. When thing turns sour and the Fed have to engineer a rescue, the players just have to sit back, play dumb and blame the market. Ultimately, the financial institutions will be very likely be bailed out by Fed; Fund managers and broker have already pocketed their bonus in good years; Fed chairman emerges the Hero.

Point 2 highlights an issue in the current financial markets: the lack of diversity. After years of consolidation, smaller players are simply gone. An investment idea can now spread across this industry like an fungi infection in a banana plantation. The financial strength and simple-mindedness of the investment community will be a root cause to more stupid yet severe financial crises in years to come. Maybe more can be said on this subject.

An article by Edward M. Gramlich of FRB on Subprime.