Though the Fed will most probably cut the Fed Funds rate by half a percent, possibly all in the September meeting, or perhaps split between September and October, I don't believe that such an easing has much capacity to eliminate the inevitable default problems ahead in the mortgage market. As Nouriel Roubini has pointed out, there is a major difference between illiquidity (which Fed operations have a good potential to offset) and insolvency (which can be offset only by explicit bailouts at taxpayer expense, as we saw during the S&L crisis). My impression is that most of the worst credit risk is held outside of the banking system, so there is little concern that losses will need to be covered by deposit insurance. A greater share is probably held by investment banks and hedge funds, and my impression is that taxpayers will be hard pressed to allow Congress to use their tax money to finance the bailout of Wall Street financiers, when they've got their own mortgage bills to pay.
As a side note, I'm intrigued that investors have been so willing to lower their guard about credit concerns and the potential for continued blowups, based on nothing but the short-term interventions of the Fed. Most likely, the worst credit risks are being held in the hedge fund world, where reporting is monthly and nobody has to say nothin' until the month is over.
And on the subject of what investors know that ain't true, it's not clear that investors should really be cheering for an environment in which the Fed would be prompted to cut rates because of recession risk. Recall that the '98 cuts were largely due to illiquidity problems from the LTCM crisis, not because of more general economic risks. In contrast (with a nod to Michael Belkin), below are a few instances when the FOMC successively cut the Fed Funds rate in attempts to avoid recession: 2000-2002 and 1981-1982. Those cuts certainly didn't prevent deep market losses. Speculators hoping for a "Bernanke put" to save their assets are likely to discover - too late - that the strike price is way out of the money.
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