Off to the Rate Cut Races

I know I promised you stock ideas in my last blog, “The Leave No Consumer Behind Act.” I still plan to give you them once I’m done reviewing the data from Sageworks, a financial research outfit.

I asked Sageworks to crunch the numbers on 6,000 companies to find the cheapest, most stable value plays with little debt and sizable cash kitties, the idea being they can best avoid the credit crunch, grow profits and bolster your portfolios. I want to get this right for you, so bear with me, they are forthcoming.

But in the meantime, I had to write to you again.

With all the talk of the Fed potentially cutting rates again, I’m reminded of what a dear friend of our family once advised me about relationships. I had just endured a breakup.

She said, “Lizzy, relationships are like hailing a taxi. One goes by, you hail the next one. The next one goes by, you hail another one.”

So with the market hollering for another rate cut, are we just hailing another asset bubble?

Cutting rates weakens the dollar which causes commodities priced and traded in dollars to spike higher. You see asset bubbles already forming in oil and gold. “Many already feel that the Fed’s behavior over recent years has resulted in a series of global asset price problems,” says Andrew Clare, a professor of finance at London’s Cass Business School and a former economist with the Bank of England. I would add that market bubbles are often caused by structural problems intrinsic to each home country (China), but yes overall gunning the printing presses doesn't help.

Set aside the lemming-like flight that's causing bubbles to develop in emerging markets. And yes it's true that a weak dollar on top of the credit crisis has caused a fire sale in America’s assets, which is why foreign money is cherry picking now. It also makes investors think twice about investing in our government paper—why invest when the returns will be microscopic? Has the U.S. replaced Japan in the carry trade, borrow low here and invest long elsewhere?

Cutting rates will not solve all of the problems in the housing market or at the financials.

That's because a rate cut can’t turn a sick mortgage into a healthy loan. Plus the Fed can only control the price of credit—it can’t force the banks to make credit available.

Months after the Fed has flooded the system with money, lenders remain tightfisted for fear that borrowers won’t be able to pay back loans. They also don't trust each others' balance sheets, so commercial lending is doing poorly too. The problems in the market and economy are not about liquidity, they’re about structural issues (see my prior blog, “Cleaning Up Wall Street’s Housing Mess").

Yes lower rates do help thaw out frozen bank lenders, helping businesses and consumers to borrow again, and they do help banks replenish their damaged balance sheets. And yes lower rates help consumers with adjustable rate mortgages, because when the loans reset to lower rates, notably LIBOR, lower payments result. Some $385 billion worth of ARMs are due to reset this year.

But there still are plenty of demonstrably bad loans that can’t be resuscitated, with an estimated one million homes expected to be foreclosed upon this year.

And now the FBI is investigating 14 companies for possible accounting fraud, insider trading or other violations after a dramatic spike in the number of mortgage fraud cases under investigation. The names of the companies were not disclosed. Bear Stearns, Morgan Stanley and Goldman Sachs have disclosed in regulatory filings that they had received requests for information from regulators, without further comment. Federal prosecutors in Brooklyn, N.Y., as well as the SEC are looking into the collapse of two Bear Stearns & Co. hedge funds. The SEC and the Justice Department also are investigating insider stock sales and accounting at New Century Financial, a mortgage lender in bankruptcy. And the FBI and the Department of Housing and Urban Development opened an investigation into the mortgage practices of Atlanta home builder Beazer Homes USA nearly a year ago.

All of this is aggravating the overarching anxiety vexing the markets: No one knows where the bottom is. Or how deep it is.

Michael Mayo, a top banking analyst at Deutsche Bank Securities and a long-time expert in the financial sector, estimates subprime losses could reach $400bn. We’ve already seen $107bn in writedowns, so this suggests $300bn more is forthcoming. Meredith Whitney, a top analyst at Oppenheimer, now says the trouble at the bond insurers could load on as much as an additional $70bn in writedowns through 2008, with the majority concentrated at Citigroup, Merrill Lynch and UBS.

Also, only a fraction of troubled loans facing sharp increases in monthly payments have been rescued via workouts. Of the more than 2 million loans on the precipice, only an estimated 54,000 loans were changed. Repayment plans were being arranged with another 183,000 borrowers during the third quarter of 2007. During the same period, lenders began foreclosure actions on 384,000 loans.

I read this great quote from Warren Buffett last weekend, that “you only find out who is swimming naked when the tide goes out.” We're only just beginning to see who was swimming naked (Citi, Merrill and UBS), plus we'll only see the bottom when the tide goes out. But the tide is going out in slow motion due to the nature of mortgage loans and the foreclosure process.

Foreclosures can be forestalled by all sorts of things, borrowers who believe against evidence to the contrary they can still pay off the loan, bankruptcies, you name it.

One reason why the credit rating agencies were so slow to act in raising fire-engine red flags to tell investors that these sub prime securities were really sludge was because they often wait to downgrade sub prime securities only until after foreclosures occurred, not when loans were delinquent. Foreclosures, they say, give a better read on assets.

Really? You experts didn't see this coming when everyone began hollering about it in 2005? How easy it is to blame it on your own system. The ratings agencies have since rocked the market in late 2007 playing catching up by downgrading securities that they only recently had rated as solidly triple A, a triple-A rating they handed out like Kleenex (for sweet fees often double what issuers paid to get plain vanilla corporate bonds rated).

And now the government in its stimulus plan wants to lift the $417,000 ceiling on mortgages that Fannie Mae and Freddie Mac can buy and guarantee to jumbo loans?

At a time when both companies are just now recovering from serious accounting scandals that caused each of them to not file quarterly reports for a number of years? When both already reported massive write downs on their loan portfolios, at a time when Credit Suisse estimates both still face a total of $16 billion more in write downs?

Weren't Fannie and Freddie created to help low- and middle-income borrowers get affordable housing? We really want to expand these massive entities when they’ve been so disastrously mismanaged?

Guess who foots the bill here: Taxpayers. Fannie and Freddie each have credit pipelines into the Treasury worth $2.25 billion each. This is beyond asking for trouble. You tell me, what do you think?

Back to the Fed—it needs to anchor inflation expectations, plus lower the market’s expectations that it will ride to its rescue after every misadventure, as it did beginning with cuts last fall and just recently.

“A policy of chasing growth at any cost may carry with it some serious risks,” says Clare, now chairman of Fathom Financial Consulting.

For one, cutting the fed funds rate to the level of inflation or below is dangerous, as inflation is far from dead, Clare notes. Headline inflation remains above 4%, and even when you strip out the rises in food and petrol prices, core inflation still stands at an elevated 2.4%.

The stock ideas are on the way.