Investoid

As I mentioned in my last post, the US Federal Reserve is under pressure from the financial markets to cut their funds rate by a quarter to half a percent. As a result of an increase in sub-prime mortgage defaults, higher risk debt issues are becoming quite illiquid. This has caused a credit crunch for some firms who rely on junk bonds and the like to finance their operations, while various hedge funds and purveyors of collateralized debt obligations are feeling the pinch from low prices and no buyers.

The fear is that this housing calamity is spreading to the rest of the US economy, thus affecting overall growth and strength in important areas such as consumer spending and business investment. A rate cut would not only spur on these areas, but would re-invigorate the credit markets. With inflation within (or close to) the Fed’s target range, they can afford to cut rates. So, why not do the ‘right thing’ and keep the economy going? In fact, with the market pricing in a half percent cut, wouldn’t keeping the rate the same just be punishing investors already spooked by the recent downturn?

Not so fast. Just because a sub-sector of the credit markets is in trouble, doesn’t mean that the whole system requires stimulus at this point. As this Financial Times articles notes, “this is far from the greatest credit correction of all time”. We are far from a wide-scale crisis at this point. Furthermore, I believe that in our financial markets one person or company’s pain is another’s opportunity. If credit markets are seizing up, it’s because the typical buyers aren’t willing to buy anymore. That doesn’t mean that the securities being peddled are worthless, just that they aren’t in vogue right now. But in these capitalistic markets there are always someone trying to get an edge. I suspect that many hedge funds and other large investment houses are re-pricing these phantom ‘AAA’ rated securities. In fact, there are several companies openly saying that this crunch will be good for business in the long term. Canadian banks also seem to think this is a good thing.

I’m not going to harp on about the Fed being in a moral hazard situation, but if you’re a Mad Money fan get Cramer to answer this: does he really think even a percentage point cut to the Fed rate will save people from losing their homes? Just because the prime lending rate goes down doesn’t mean that high risk rates will go down as much, or even at all. In fact, I would guess that such rates will increase, regardless of what the funds and prime rates do, because of the higher perceived risk of default. And if a person who’s in an adjustable rate mortgage whose teaser rate is about to end and his new rate will be prime + 3% or more, do you really think that a 100 basis point cut will really matter in terms of his monthly payment? Assuming that the person has a $200,000 mortgage on a 25 year amortization and had a teaser rate of 4%, they would have paid $1047 per month. Assuming their new rate is prime + 3%, then at current rates their monthly payment is going to be $1918, while their payment with a percentage point cut would be $1795. Either way, if the person wasn’t ready to pay 90% more in monthly housing costs, I doubt they’re going to be ready for a 70% increase either.

The bottom line is that capitulating to the financial markets desire for continuing cheap money does nothing to wring out the excesses currently in the system. By prolonging their existence, they are more likely to cause long term harm, as we have seen in Japan’s sclerotic economy since their own real estate bust. Because Japanese banks weren’t able to go out of business or even fully disclose their bad loans, the excesses were never fully brought to bear. Only in the early 2000’s did a special task force make Japanese banks own up to their bad debts. Despite their 0% interest rates for many years, their economy has continued to stagnate. I’m not suggesting that this is the only reason for Japan’s continued growth lag, but it is a contributing factor.

I don’t expect the Fed rate to remain at 5.25% on Sept 18, but I think there is a strong case to be made that it shouldn’t be reduced. If the board of governors decides to only cut by 0.25%, expect to find many bargains around the world that day.