Curb Your Enthusiasm

Yesterday, September 18, the Fed cut rates by 50 basis points leaving the discount rate at 4.75% and the target Fed funds rate at 5.25%.

Markets have responded favorably with bank and financial stocks moving dramatically higher. The CEOs of major mortgage lenders, Autonation and Darden Restaurants campaigned actively for this cut over the last several weeks, got it, and have seen their stocks move higher. To boot, every analyst of TV is saying that this is a wonderful time to buy bank stocks and that these companies are about to recover. I however don't share their enthusiasm.

Credit markets continue to be largely closed. While they may loosen as a result of lowering rates, they aren't going to open. Increasing liquidity will not reverse the poor loans that are on the books (mortgage or otherwise). Banks and other companies that are full of this stuff will be forced to eat it in the form of mark-downs for quarters and years.

The only way that one can anticipate banks actually benefiting is to assume that this is a top up approach to saving a declining housing market which will increase the creditworthiness of otherwise less valuable mortgage loans and other credits on the books. I believe that the housing market is a bubble which needs to deflate - the deflation can be postponed, but it is going to happen as many areas are dramatically overbuilt and have much too much inventory. Plus, the market is twice as high as it was 5 years ago.

Now, let's look at your average fool who jumped into a house in LA at the peak three years ago with an ARM that is about to adjust and an equity line of credit. This guy has already seen a decline in his home price of 10% and is looking at another decline of about 25% over the next two years before there is any supply - demand balance in housing. The lowering of rates may lower the rate of the equity line of credit (usually tied to Prime), but isn't going to materially affect his ARM. Data that I have seen from a leading mortgage lender shows that ARM rates nationwide are roughly evenly tied between three components - LIBOR (which the Fed cannot directly affect and which may very well continue to gravitate upwards in spite of the Fed's move), the 10-year Treasury (which is actually trading higher after the Fed's cut than it was prior to the Fed's cut) and Prime. Therefore, any impact on this guy's ARM from the Fed's move is likely to be marginal at best, and is more likely to postpone a default or a sale than to avoid one. The reality actually is that this fool is better off coming to terms with what is about to happen and trying to get out of his house today than to be misguided into thinking that the Fed is going to continue to help him (and ultimately need to sell in 2 years at a much lower price).

I may be wrong, and I've been wrong before. But, against these realities I believe that this is nothing but a bounce.

I also believe that Bernanke is solid, and I am concerned that he acted upon economic indicators that may not be fully available indicating that the economy is deterioriating. I actually would have expected a 50 basis point cut to lead markets down. As I have written before on this website, I believe that GE is an excellent short here.