When it comes to interest rates, the old adage says that “the Fed raises rates until something blows up.” In fairness to Bernanke and co., the FOMC have reduced interest rates (arguably too late) but true to the old adage, something blew up. In this case it wasn’t a company, it was an entire asset class and those companies involved with it, even peripherally.
The “Sub-prime Crisis” is not easy to explain or decipher. The bottom line is that banks and others (mortgage lenders) extended credit to borrowers (homeowners), allowing them to buy their “dream homes.” The problem is that these houses should have remained dreams for these people and never, ever become a reality. Since the banks knew these loans were high risk, they attempted to offset it by pooling these high-risk loans together into pools, thereby selling pieces of these pools as securities, most commonly known as CDO’s or CMO’s.
Because of the buoyancy of the housing market and the high level of interest in participating from financial institutions, these securities were traded, leveraged off of and even repackaged with similar debt to generate trading revenue.
The way it looks now is that this asset class is like a road: many miles long, but only a few inches deep.
Take into account that many homeowners have foreclosed, those whom haven’t face mortgage resets to higher rates in the near future and that many market participants (mortgage brokers, banks and divisions) have gone out of business—liquidity has disappeared and the market for these securities has essentially frozen.
Since the financial markets are global today, it facilitated the spread of this sub-prime contagion into other sectors, mainly the Asset Backed Commercial Paper market. It has also had the obvious consequence of banks adopting stricter lending policies in general, sending borrowing costs sky high, which in turn hurts capital investment and R&D.
Returning to the Federal Reserve, Chairman Bernanke has maintained a position of returning liquidity to the market though firmly renouncing any idea that the FOMC will bail out speculators. Mr. Bernanke has also distanced himself from the response of his predecessor to any liquidity crisis which entailed cutting rates until the problem is solved. Instead, this FOMC (while reducing rates) has indicated it will be more active in the machinations of the bond markets, specifically in REPO’s—allowing institutions that are strapped for liquidity to either visit the Fed’s discount window or pledge their troubled debt as collateral for loans to ease the credit squeeze.
So far, the market has not been thrilled since the last FOMC meeting when it was made public —while the Fed recognized the risks—that the last cut was not supported by all members and further cuts looks unlikely.
Anytime market participants take on the mindset of shooting first and asking questions later, the result usually wind up bringing a scenario that produces the “capitulation” selling that pundits preach will become the basis of a market bottom. Most times the shooting is patently absurd and unnecessary, but took place because policy makers opted to be reactive instead of proactive. One of the many criticisms leveled toward the new Fed head is that he is an academic, with little practical experience.
Since the emergency cut and the many REPO interventions, things have gone from bad to worse in the market. Many of the largest banks and brokers have been forced to take write-downs in the $billions and everyone still feels as though they are looking into an abyss. Until investors are able to get their arms around what the damage is—or unless they are confident that the risks are not overwhelming, money will simply remain on the sidelines.
Nobody wants to own the next Citigroup ($47 down to $31 in 19 days) or the next Countrywide Financial ($17 down to $9 in 17 days) and they are clearly worried these companies will be forced to undertake major layoffs, purchasing cuts and the like that will spread throughout the economy as others follow suit.
More things will “blow up” unless the fed expands the scope of their campaign beyond the REPO market and discount window. Companies like Northern Rock, Bond Insurers like Ambac, the Credit Rating Agencies like Fitch and others will have their financial health put into question unless borrowing costs ease and liquidity returns to the fixed income market.
I understand the Fed is preoccupied with the inflation stemming from high commodities prices but if the entire bond market seizes up and sends the economy tumbling—$95 oil will be an afterthought—regardless of how much China is buying.
