Fed Rate Cut Encourages Undue Risk

Lately, my clients have been reminding me of the annoying kid in the back seat of the car who keeps asking, “Mommy, Mommy, are we there yet?" "There", in this case, is the market bottom. I am forced to respond that I will know better after the next turn.

Last Friday, the Federal Reserve lowered the discount rate it lends to banks by a half percent to 5.75%. The more closely watched fed funds rate was left alone. After the Tokyo markets suffered their worst one day decline in seven years coupled with the recent volatility in the American market, the Fed felt it had no choice but to act.

The rate cut was an important psychological boost for the market. Without their de facto bailout, the stock market would have plunged on the opening. Instead it rallied up over 300 points on the opening and then settled in a range of up 100 points. This is hardly a strong showing considering the trouncing the market has taken in recent weeks.

I suspect that this bailout is a band aid, not a permanent fix. Wall Street likes when the central bank feels its pain. James Cramer, of the Street.com, famously broke down and cried on CNBC last week begging for a rate cut. Over a million people clicked on YouTube to see his tears.

This rate cut may be Fed Chairman Bernanke's way of saying, "I care, but it scares me." By the time that most of us reach adulthood, we stop expecting the tooth fairy to put cash underneath our pillow. This is true for everyone but the Lamborghini driving, champagne drinking hedge fund operators. Even though they pocketed obscene amounts of money during the good years, they do not think that they should be made to pay the piper now.

They are insisting that the Federal Reserve bail them out. It does not make sense to me that billionaires are being rescued at the expense of ordinary Americans. Memo to the Fed: these are not the miners trapped in a Utah mine without air.

Risk is vital to our economy. It spurs innovation. But the same thing can not be said about too much risk. With this rate cut, the Federal Reserve has acted as an enabler to the hedge fund community. They are feeding their addiction to risk, the heroin of choice for hedge fund manager. Why inject drugs into your body when you can gamble with other people’s money for a high?

Instead of holding them accountable and literally making them pay for their mistakes, our central bankers are fueling their codependency on leverage. In their insatiable thirst for profits that could line their cashmere pockets, the hedge funds have often leveraged their investments beyond rationality. Some mortgage investments were leveraged 95%. With that kind of leverage, there is no margin of error. At certain periods in the market, it may be acceptable to climb out on the ledge of a very tall building, but is never acceptable to hang on just by your fingertips.

With this rate cut, the Fed is encouraging risk in a market that already takes too much risk. They are as cruel as someone who force feeds a diabetic a doughnut. The hedge fund managers get paid very well when they bet right. If they make a mistake, the American people should not have to rescue them. With no penalty to pay for taking too much risk, there is no reason for the hedge fund managers to stop taking risk. An addict has to hit rock bottom before he is willing to reform his wanton ways.

My advice to my clients is to take methadone instead of pulling the trigger and buying stocks. It is still too early, even though the crisis seems to abating. Investors in hedge funds have until August 15 to notify the fund for a third quarter withdrawal. I am not predicting a mass exodus, but I do not want to get crushed in the event of a stampede.

The market was rocked last week by the announcement from the nation’s largest lender, Countrywide, that it was unable to go to the market for now and was forced to tap the banks. Some analysts are betting that it is too big too fail. I do not like to take those bets. The Street is littered with companies too big to fail. Chrysler in the early eighties, many savings and loans, and the electric utility Public Service of New Hampshire come to mind.

As Countrywide fell almost 50% at one point last week, KKR Financial fell 31% in one after it announced financing problems. KKR Financial is run by the savvy people at Kohlberg Kravis that should have been as prepared as Eagle Scouts for this crisis. There is no way of knowing who will be next. Any current valuations of mortgages and collateralized debt are as much fiction as Jackie Collins’, “Hollywood Wives”.

Some of my caution stems from the lack of unfired weapons in the Fed’s arsenal. They have already pumped money into the economy and lowered the discount rate. Only a Fed funds cut remains.

Comments

[Sr. Pessimist:]

I want the rate cut. I want the US Dollar to continue its decline. The US Dollar lynch pins the evil this country suffers by. I want a Mexican peso worth more than a US Dollar. I'm sick of the US economic policy. Like the above, scum kleptocrats always get the free money. So let their rmoney valuate to what it's worth- absolutely nothing.

2007 Aug 23 12:56 PM