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The Federal Reserve stepped up this week and gave Wall Street what it wanted — another half-percentage point cut in interest rates. That brings the federal funds rate down to 3%, the lowest level since the middle of 2005.
Today I want to take a closer look at the Fed’s action, to find out what it will — and won’t — do. Let’s start with …
How the Fed Rate Cuts
Will Impact Consumers
First, two minor positives …
Some mortgage holders will not see as large an increase in the rates and payments on their adjustable rate mortgages. That’s because funds rate reductions are now lowering the London Interbank Offered Rate, or LIBOR, that many such mortgages are tied to.
Rates on home equity lines of credit will come down as well. That’s because they’re tied to the prime rate, which essentially mirrors changes in the Fed funds rate.
Unfortunately, the rate cut also comes with a long list of major negatives …
For one thing, savers will get hit again. Rates on Certificates of Deposit and money market accounts will likely fall in the wake of the latest cut.
For another, the cuts will NOT help falling home prices. Rate resets aren’t the only threat to mortgage borrowers and loan performance right now. Falling home prices are a much bigger deal.
The more home prices fall, the further underwater borrowers become, and the more incentive borrowers have to just give up and walk away from their loans.
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The latest S&P/Case-Shiller report showed prices falling 7.7% from a year ago in November.
That’s the worst drop on record!
Overall, prices were down in 17 of the 20 metropolitan areas the firm tracks. And even cities that were reporting nice year-over-year gains are starting to fade.
The National Association of Realtors’ figures show the same general trend — the median price of an existing home fell 6% in December vs. the same month a year earlier.
What about new homes? More bad news. The National Association of Realtors’ figures show prices fell 10.9%, the sharpest decline in any month since 1970.
So, as you can see, many consumers are likely to remain strapped despite lower interest rates. And at the same time …
The Fed Rate Cut Won’t Magically Solve
The Financial Industry’s Problems Either
The fashionable thinking on Wall Street is that these Fed cuts will restore bank profitability and allow major institutions to put the financial crisis behind them.
I’ll grant that these cuts will help firms pick up some extra interest income. That’s because long-term interest rates will move higher relative to short-term rates.
But unlike past financial crises, and their Fed-fueled recoveries, we’re dealing with a different animal here. It’s not just one category of loans — like, say, commercial real estate — causing all the problems. Nor is this just an isolated hedge fund blow up like we had in 1998 with Long-Term Capital Management.
Instead, we’re seeing delinquencies rise in many categories of loans:
Mortgage defaults and foreclosures have been soaring for a while. In fact, foreclosure filings surged 97% year-over-year in December.
Plus, write-downs are coming from everywhere and the value of complex debt securities that banks are holding on their books is slumping fast.
Standard & Poor’s just put out a report suggesting losses from subprime-related mortgage securities could top $265 billion — with a “B” — at regional banks, credit unions and other financial firms.
S&P also either cut ratings or put its ratings on review for a whopping $534 billion worth of mortgage bonds and so-called collateralized debt obligations (CDOs).
IMPORTANT: That’s roughly half of ALL the subprime bonds S&P rated in 2006 and early 2007!
Many banks and brokers are also stuck holding tens of billions of dollars of leveraged loans — financing used to fuel the recent corporate takeover boom. Those loans are also losing value.
Bloomberg recently reported that banks are stuck with a $230 billion pile of high-yield, high-risk debt. That includes $160 billion of leveraged loans and $70 billion of junk bonds.
Meanwhile, a basket of loans that S&P monitors recently traded down to about 91 cents on the dollar. If this continues, we’re going to see yet ANOTHER batch of write-downs among the major financial companies.
If That’s Not Bad Enough,
The Bond Insurance Debacle
Is Getting Even WORSE!
Bond insurers are firms that take on credit risk tied to municipal bonds and complex debt securities. If too many bonds default, they have to pay out big bucks to the companies that bought insurance from them.
Now, many of the more complicated securities they’ve backed in recent years are blowing up. That means future loss estimates are rising higher and higher.
Moreover, the bond insurers are seeing their own portfolios lose value.
MBIA, the world’s biggest bond insurer, just said it lost $2.3 billion in the fourth quarter.
That’s a GIGANTIC $18.61 per share — the biggest ever quarterly hit!
A key reason: It took $3.4 billion in losses related to markdowns on residential and commercial mortgages and CDOs.
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| Fitch Ratings has already downgraded two bond insurers … |
Fitch Ratings is already starting to downgrade the bond insurers. It just cut Financial Guaranty Insurance Co., or FGIC, to AA from AAA, and it recently cut its rating on another company, Ambac Financial, to AA from AAA.
The larger credit ratings agencies, S&P and Moody’s, could follow suit. And that could result in billions MORE in write downs for financial firms.
In fact, Oppenheimer & Co. said bond insurer downgrades could force banks to take $70 billion in fresh write-downs.
And Barclays Capital said banks could be forced to go hat in hand — again — to investors in order to raise ANOTHER $143 billion in capital to shore up their balance sheets.
So, Despite the Rate Cuts, I Continue to
Suggest Staying Away from Most Financials
Right now, you have a choice:
Drink the “All our problems are going away! Yippee!” Kool-Aid and buy everything in sight.
OR …
Think about the magnitude of the problems we’re facing and ask yourself whether you really believe they can all be solved by Ben Bernanke’s magic interest rate wand.
By now, you know which side of this debate I come down on!
I think the process by which we purge all the excesses of the credit boom will take a long time to play out. And that means most financials are still not worth touching.
Until next time,
Mike
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