Stock Markets: Look out Below!

As folks who're following the economy & sub-prime crisis know, many in the financial media have been howling for a rate cut from the Fed since August...It may not be a foregone conlcusion...

Many Fed watchers believe the Fed district bank presidents are more reluctant to cut the federal funds rate than the members of the Fed board of governors.
In the past few days, some bank presidents have stressed that the Fed must avoid the "moral hazard" problem by bailing out investors who took excessive risk.
Plosser put it this way: "It is not appropriate for the Fed to ensure against financial volatility per se, or against individuals or firms taking losses or failing."
Plosser suggested that he is not yet certain whether the tight credit and financial turmoil is a "temporary disturbance" that would not throw the economy off track or a "shock" that would require a rate cut.
"I believe it is important to understand and appreciate this underlying stability of the economy in the face of temporary disturbances as we seek to assess monetary policy in the face of developments in housing," Plosser said.

It is of course the Federal Reserve Board of Governors who make the actual decision to set the Federal funds rate; but the idea that dissenting voices exist in that corporate world is intriguing.

Meanwhile, next week might see some kind of Armageddon in the commercial paper market, at least in the UK (and all this stuff is connected now):

LEADING bankers are warning of the worst crisis in the money markets for 20 years, which will come to a head this week when $113 billion (£57 billion) of commercial paper – market IOUs – comes up for refinancing.

This huge refinancing, mainly through London, exceeds the $100 billion that became due in mid-August, and which sparked the most serious phase in the money-market crisis, which has seen banks scrambling for funds and market interest rates rising sharply. “This is a serious pressure point,” said one leading banker.

Another senior executive of one of Britain’s top five retail banks said: “These are the worst conditions I have seen in money markets for 20 years”.

The huge amount of commercial paper becoming due is the hangover from the crisis in credit markets that began with American sub-prime mortgages. Many of the off-balance-sheet structured investment vehicles (SIVs) set up by the banks were borrowed in the form of asset-backed commercial paper.

It may be impossible for central banks to avert this crisis, because the issue is may be much, much bigger than the sub-prime market.
Here's something I wrote on my own blog almost two years ago.

There's the war in Iraq, there's bird flu, there's soaring oil prices, there's the trade deficit, the Federal deficit, bad emergency response in Santa Ana season... but I bet you never worried about collateralized debt obligations.

Neither did I until I read the above link.

As Jim Jubak wrote way back then:

To understand this epidemic of risk, why it is such a danger to the global financial markets -- and us -- and why the Fed can't do much about it except jawbone, you can try to master the details of the $8.4 trillion market for something called credit derivatives. Or you can answer one simple question about the airline industry.

That's the issue: the sub-prime crisis may not be a cause of the market instability, but a symptom of something much, much bigger.

It wasn't just home-buying deadbeats who were getting loans for houses, but it was deadbeat companies like airlines who were getting loans.

And none of this crap can be valued correctly at present.

And no bank wants to loan if they don't know what the collateral's value is.

Look out below.

And also take all the financial media with a grain of salt...for example, this bit from Forbes...

Subprime Risks: Overblown


...On the other hand, financial stocks are one of the biggest weightings in my portfolios. As a professional investor for 25 years and an owner of an investment firm, I know this area firsthand. So for me, the real lesson behind a circle of competence is that it gives me the courage to buy and hold stocks during market dislocations and not wait for things to calm down.

Hmmm...I don't suppose he thinks the title is apt because if it's not overblown, (or if as is noted above, it's a symptom and not the cause) then his "circle of competence" isn't.

Here's another gem from Forbes:

The Fall 2007 Rally

...What makes me so sure that we're in a rally, not a long-running decline? Four things. The first has to do with the shape of a bull market termination. The final peak does not arrive sharply. It tends to have a gentle upward slope, as the final but diminishing round of suckers is drawn in. And then the decline (usually) begins with a gentle slope, too (October 1987 was the exception proving the rule--over almost instantly), as some buyers continue to come in even after the bull market is over. The bull market leading up to the July 16 peak was too sudden and the plunge too sharp to presage a real bear market.

Second, bear markets don't start from old news. In this case the old news is that many subprime borrowers are going to default on their mortgages. While this misfortune is still unfolding, the basic facts have been out for a while. A fundamental rule of markets is that old news runs out of power. It takes new information to move stock prices.

Third, it usually takes a severe credit crunch to set a genuine bear market in motion. This credit crunch, at least for corporate borrowers, is not severe. You measure crunch by the spread in yields between junk bonds and Treasury bonds of like maturity. In 2000 that spread widened by three to four percentage points, a harbinger of both a broad tumble in stock prices and an economic contraction. In that case, moreover, the widening spread came atop rising Treasury interest rates--weak corporate borrowers had two strikes against them. Contrast that with what's happening now. Junk spreads widened by only a percentage point before going back the other way, and much of the widening was from a fall in Treasury rates, hardly bearish. This is a phony credit crunch.

Yeah, trillions of dollars worth of debt can't be accurately valued as to its risk/return profile, and this credit crunch is phony.

It's not phony; even people with good credit are being turned away right now.