August 2007

Recession?

The sub-prime loan debacle has spread to just about all areas of the credit market and is taking a toll on investor’s emotions as all sectors of the stock market, and in particular, the financial sector, are retracing year-to-date gains. As the old adage goes, “When you can’t sell what you want, you sell what you can.” It will likely take some time before all the cards are face up and the risks to the broader economy are better understood. Although the Federal Reserve is showing a willingness to pump liquidity into the system by lowering the discount rate by 50 basis points, the rate at which banks can borrow from the Fed and typically used for “overnight emergency funding”, there are limits to the Fed’s influence. At this writing, the discount rate is still 50 basis points above the federal funds “target” rate at 5.25%. It is our guess that any action by the Federal Reserve is likely be a further reduction in the discount rate with no immediate revision to the federal funds rate at its upcoming meeting on September 18th. It is our opinion that the Fed would like to wash out some of the excess liquidity (created by Mr. Bernanke’s predecessor) that has been instrumental in creating the stock market bubble of the 90s and the current housing bubble. With the discount rate still above the federal funds rate, banks are reluctant to borrow at the discount window - only $2 billion borrowed since the Fed’s rate reduction. We suspect that the credit markets will remain in a whirlwind until credit market risk has been reliably re-priced. In recent weeks, a rush to safety has pushed shorter-term yields on government securities to new lows. It appears that Mr. Bernanke and Fed would like to see the markets do further work in culling soured loan portfolios before offering any additional “bailout” attempts, i.e., lowering the federal funds rate. Additionally, Mr. Bernanke and the clan must try to retard the rapid devaluation of dollar in foreign exchange markets if the U.S. expects to keep its world reserve currency status.

Economic indications of rising unemployment and further retrenchment in consumer spending would raise many eyebrows at the Fed. Of particular concern is a recent study by Merrill Lynch in which it pointed out that distressed homeowners may by turning to credit cards before being forced into foreclosure. The Merrill Lynch study noted that balances on consumer credit cards jumped at an annual rate of 11% in May and June – marking the highest rate since the recession of 2001-2002. Typically, consumers run up revolving debt (credit cards) when they are upbeat about economic prospects. However, retail sales of late have been sluggish, reflecting a pullback in consumer spending. If this trend continues and is an attempt by the consumer to put off the inevitable and/or stash cash away before entering into foreclosure and bankruptcy, we could be headed for a surge in credit-card defaults in coming months? In our opinion, the question of recession towards the end of the year (or early into next year) remains firmly on the table at this time.