A Perilous Dichotomy

The reaction to the Fed Rate Cut has unfolded largely as discussed here two weeks ago. The scenario currently given the most credence is that inflation will run out of control as the dollar depreciates rapidly against commodities and other currencies. Gold is nearing all time highs and is currently near $750 an oz, oil and food prices are also taking off.

The stealth move which is largely ignored for the time being is the real estate debacle which is slowly and steadily unfolding. The financial media and most of the pundits seem to have the response of - OK - the Fed has cut rates, the worst is behind us - lets move on to the next story. The problem is - this is the crisis that just will not go away for the next several years. Get used to the phrase - all subprime - all the time as the new slogan for Bloomberg and CNBC - because the real estate crisis has just begun. This has negative implications for banking and financial stocks.

We are just seeing the first slew of writedowns affecting the banks which are related only to the sub-prime sections of the mortgage securities market. Still in the pipeline are impairments resulting from a 50% drop in collateral values. Take WAMU for example - they love to cite their LTV ratio in the 50-70% range as of September 2005 and September 2006 underwriting time. The problem is that after home values fall 35-50% - the new LTV ratios are 100-120% - leaving zero margin for air in the case of a foreclosure.

As credit risk is reintroduced into the mortgage backed securities market we should see a continued tightening of credit to the Jumbo loan market. As the credit is cut off Mortgage Equity Withdrawal gets hit and consumer spending goes in the crapper. All of these variables combine to give us a recession in the USA.

The tragedy of most of the hot money mutual fund managers as this point is they have soiled themselves thinking about how the Fed rate cuts will affect the financials have jumped in hand over fist buying the regional and money center banks - under the idea of bigger Net Interest Margins. This analysis is a mistake because it ignores the collateral and credit risk side of the equation.

Anyways - I can't say that I am surprised to see this blow off in commodities, gold, and foreign equities right now, but I will insist that it is not a good entry point. That is to say - the more those markets run - the greater the fall will be when the world realizes the USA is in a full blown recession. Long volatility (e.g. commodities and emerging markets) will prove to be a very scary play at that point. We've already had the first scare about two months ago. I expect the second this fall.

-BG