Fed Cuts, Market Loses Gains, Ratings Downgrades Coming

Posted by urbandigs

Wed Jan 30th, 2008 03:53 PM

A: I think reality is setting in that there is a reason the fed is acting so aggressively; risks to the economy. The drug injections Ben handed out today obviously wasn't his best stuff and the addicts on wall street feel shafted. In the meantime, reality wakes us up. Fitch cut the rating on FGIC, the 4th largest bond insurer and S & P lowered, or may lower ratings on up to a half a trillion, thats trillion with a 'T', of subprime mortgage securities and CDO's.

It brings me no pleasure to say that reality beat out a drug induced fantasy today on wall street. The fed used more of its precious ammo and cut both the FFR & Discount window by 50 bps, yet markets sold off by the end of the day due to the realization that there are valid reasons why the fed is acting so aggressively. Meanwhile, expect commodities to rise and inflation pressures to rise in the years to come as the fed clearly is pulling out everything in its arsenal to combat the problems bubbling under the surface. Sooner or later, a billion dollar write down starts to mean something.

Since the rate cut is not news anymore, lets get to what spooked the markets. According to Bloomberg (via Calculated Risk):

Standard & Poor's said it cut or may reduce ratings of $534 billion of subprime-mortgage securities and collateralized debt obligations as default rates rise.

The downgrades may extend losses at the world's banks to more than $265 billion, S&P said.
Then came Charlie Gasparino and his gut instinct of bond insurer downgrades coming as early as today; recall posts on UrbanDigs here & here and here about this possibility and likely effects. Then it happened. According to Bloomberg (again, via Calculated Risk):
Financial Guaranty Insurance Co., the world's fourth-largest bond insurer, lost its AAA credit rating at Fitch Ratings after missing a deadline to raise capital.

Financial Guaranty, a unit of New York-based FGIC Corp., was cut two levels to AA, New York-based Fitch said today in a statement. The company had been AAA since at least 1991. Moody's Investors Service and Standard & Poor's are also reevaluating their ratings.

The loss of the AAA stamp jeopardizes ratings on bonds Financial Guaranty insured and limits the company's ability to generate new business. FGIC, along with MBIA Inc. and Ambac Financial Group Inc., are paying a price for expanding beyond their traditional business of backing municipal bonds to guaranteeing debt linked to riskier subprime mortgages and home- equity loans, as well as collateralized debt obligations.
As bond insurer's get downgraded, further write-downs in the financial sector becomes a reality. Again, we just don't know who holds what, whats insured, for how much, will the claims be paid, and on and on. Its all interconnected and being fueled by a slumping housing market, rising defaults, and a dysfunctional secondary mortgage market where these securities trade.

What does this all mean? A few things come to my mind:

a) The fed is on our side. While we have pain to go through until the ship is righted, when the clouds clear there will be another fed assisted economic boom. The question is when. This will certainly help, but I'm afraid it will take some time.

b) I love gold.

c) The fire is fueled by deflation in housing prices across the country. As home values fall, so does equity withdrawal strapping the homeowner. Those holding homes whose loan balance now exceeds the value of the asset, are considering walking away from their homes. Those who cant afford to pay their mortgages, simply aren't. Its becoming socially acceptable to go into foreclosure these days as that may be the best financial option for the struggling homeowner. And guess who lent out the money, bundled it into a security, and sold off the bond to investors who are now holding the toxic waste?

d) As defaults rise, holders of the securities derived from these debts lose. Hence the billions of losses you are hearing about. So far, we've seen the lowest quality homeowners get hit; naturally. Risks to other debt classes?

e) Leverage. The unsustainable housing boom built from lax lending standards, rising home prices, speculative investing, and low low rates was leveraged up the wazoo! That makes the problem that much more complex and is clear by the struggling financials and those who bought up the risk globally. We will have to fix the financials before we can get through the downturn. Its clear the fed knows this and is taking aggressive action! It will help, but it will take time.

f) Over-estimating Losses? A very valid hope! It is entirely possible that if all this stimulus helps to stabilize housing as time goes on, that losses are overestimate. Way too early to tell now, but certainly a valid hope that I am clinging to and watching out for. I am NOT in this camp right now.

We will get through this. But we are talking about a housing/debt fueled problem, so it will take time. Housing is an illiquid asset, as opposed to stocks, and take time to sell on the open market. With inventory outside Manhattan a concern, it will take time to work through this process. All eyes should be on housing data for signs of:

1) decreasing iventory
2) rising sales volume
3) decreasing absorption rates

...for any clue as to when the clouds may clear.

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