Being Street Smart 8/31/7

BEING STREET SMART
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Sy Harding


WHAT DID THEY REALLY SAY? August 31, 2007.

It seems like ages ago. Such has been the volatility. Yet it’s been only seven weeks since the Dow spiked up to a record 14,000 on euphoria that the economy was in ‘Goldilocks’ condition, neither too hot nor too cold. The Dow then lost 820 points after troubles at Bear Stearns hedge funds exposed how far the mortgage mess had spilled over into the rest of the financial sector.

It then managed a brief rally of 476 points over three days, until lenders, hedge funds, and investors realized their risk in corporate-backed securities was similar to their exposure in mortgage-backed securities. The financial sector ‘froze up’, with investors refusing to buy debt-backed securities of any kind, and banks unwilling to make loans if they couldn’t sell the debt risk to investors. The Dow plunged 1,140 points to a new low, in just 6 trading days. That was just two weeks ago.

At that point even the Fed seemed to panic. It rushed in with a ‘window-dressing’ cut in the ‘discount rate’, the rate that troubled banks pay to borrow money from the Fed. The market pendulum swung again. The Dow bounced 532 points over the next 6 days to its close a week ago. However, nothing had really changed, so the market sold off again, losing 336 points the first two days of this week, not helped by reports that existing home sales had fallen again, and the glut of unsold homes surged up another 5.2% in July.

By Wednesday Wall Street was concerned again, predicting the Fed would have to respond, and that Chairman Bernanke would make it clear in a speech on Friday that the Fed is going to cut actual interest rates, rather than just the discount rate for banks. The Dow closed up 247 points on Wednesday in anticipation.

The market also closed up Friday, after Bernanke’s speech, and a later press conference by President Bush, were interpreted as bullish (although the market closed down for the week).

But let’s ignore Wall Street’s bullish spin and look at the speeches for ourselves. What did Bernanke and Bush really say?

Bernanke was considerably more pessimistic than he has been recently. He said, “The further tightening of credit conditions, if sustained, would increase the risk that the current weakness in housing could be deeper or more prolonged than previously expected, with possible adverse effects on consumer spending and the economy generally. . . . . . . global financial losses have far exceeded even the most pessimistic projections of credit losses on those loans. . . . . . Inevitably, the uncertainty surrounding the outlook will be greater than normal, presenting a challenge to policymakers [the Fed] to manage risks.”

That all sounds quite negative.

So what did Bernanke say that Wall Street took as a positive?

“The Committee continues to monitor the situation and will act as needed to limit the adverse effects on the broader economy that may arise from the disruptions in financial markets.”

So, Wall Street is hoping things get worse not only in the economy but in the financial markets, because only then will the Fed cut interest rates.

In a warning to investors Bernanke also said, “It is not the responsibility of the Federal Reserve - nor would it be appropriate - to protect lenders and investors from the consequences of their financial decisions.” And he explained that even if the Fed were to lower interest rates it would not necessarily have the positive economic effect it has sometimes had in the past.

In his speech President Bush said, “The financial markets are in a period of transition, as participants reassess and re-price risk. This process is going to take more time to fully play out. As it does, America's overall economy will remain strong enough to weather any turbulence.”

So the president and his advisors expect prices of homes and markets to continue to ‘re-price’ over time, but are not unduly worried about it because the economy will remain strong enough to withstand that ‘turbulence’.

He then addressed his main concern, saying, “Unfortunately, there have also been some excesses in the lending industry. This led some homeowners to take out loans larger than they could afford . . . . Some borrowers are now unable to make their monthly payments, or face foreclosure. . . . . The government has got a role to play - but it is limited. A federal bailout of lenders would only encourage a recurrence of the problem. It's not the government's job to bail out speculators, or those who made the decision to buy a home they knew they could never afford.”

Well, that’s plain enough.

His cures for the situation; “Many homeowners could get through this difficult time with a little flexibility from their lenders . . . So I strongly urge lenders to work with homeowners to adjust their mortgages.”

He also said, “The FHA will launch a new program that will allow American homeowners who have got a good credit history, but cannot afford their current payments, to refinance into FHA-insured mortgages.”

However, the problem is not with homeowners who have good credit, but with those who have poor credit after getting in over their heads in the credit/debt bubble.

I just don’t see what investors saw as being more positive than negative in either speech.

So, I expect the volatility will continue.




Sy Harding is president of Asset Management Research Corp., publishes the Street Smart Report newsletter, and a free daily Internet blog at www.SyHardingblog.com. He also authored the 1999 book Riding The Bear – How To Prosper In the Coming Bear Market.