We will see another run of correction on the way

History tells us it's usually foolhardy to doubt the power of the Fed to bail out financial markets, once the Fed starts a cycle of lowering interest rates. But the Fed is not all-powerful. The subprime/credit crisis is probably causing a lot of collateral damage in the multitrillion-dollar over-the-counter derivatives market. It's not like the Fed can immediately wipe the slate clean on every bad derivative trade made by hedge funds and banks. Much of the damage has already been done, no matter how the Fed responds. So this Fed easing cycle may be very different from prior ones.

It's also the case that the discount rate is more symbolic than effective in today's complex credit markets. The heart of today's credit market lies beyond the realm of old-fashioned banks…and therefore, beyond the realm of Fed rate cuts. Much of the credit risk that everyone's so worried about remains hidden on hedge fund balance sheets, transferred there via highly sophisticated derivative markets.

Downplaying the significance of Friday's rate announcement, veteran trader Dennis Gartman describes a dour future for the mortgage market:

"The decision to cut the discount rate and to open up collateral to mortgages and the like 'is not a shot of adrenaline to the economy, but is instead a shot of penicillin.' That is, the Fed is not moving to expand economic activity; it has moved to stem the spreading of contagion. If anyone actually believes that the nation's financial intermediaries are going to go out and suddenly become expansive once again, extending more mortgages at anything other than onerous terms, they are sadly and badly mistaken [emphasis added]. Having once been burned, the nation's banks et al. shall be like Mark Twain's cat that having once sat upon a very hot stove shall not sit upon any stove again, for they shall all look hot to him. The Fed's action on Friday has done nothing other than to quell the fever. The patient is far, far…very far…from being healthy. The Fed has not staved off recession; it has simply made the recession that is now upon us less likely to devolve into something much worse…and for that alone, the Fed is to be lauded!"

Perhaps the Fed should be lauded because its announcement temporarily restored market confidence, but the mortgage crisis is far from over. As Gartman correctly observes, the Fed's recent maneuvers may help the nation's mortgage lenders to avoid disaster, but the days of EZ credit are dead and gone. And now that banks will be much stingier, homeowners will not be able to refinance their upwardly re-setting ARMs and homebuyers will not be able to qualify for attractive mortgages. Even in the best of circumstances, therefore, banks will be issuing far fewer mortgages than they did during the Halcyon days of 2005 and 2006.

Unfortunately, banks that do not make loans do not make money. Many Wall Street analysts have been slow to recognize this fact, and are still expecting decent earnings from most banks. They are dreaming. At the same moment that banks will be making fewer loans, they will also be setting aside reserves to cover the bad loans they made in the past. So earnings will be squeezed from both ends at once.