When assessing the current turmoil in the financial markets, I am reminded of the events of Hurricane Katrina and the similarities between the ostensibly different situations. Hurricane Katrina was the costliest and one of the five deadliest hurricanes in the United States' history. Nearly every levee (federal flood protection) in New Orleans breached as Hurricane Katrina passed east of the city, flooding 80% of New Orleans and many neighboring parishes for weeks after the disaster. So I pose the question: Was more damage caused by the hurricane itself or the flood that resulted?
Considering these circumstances, if we had the chance to prevent the federal flood protection levee system from failing in Hurricane Katrina, everyone would have asked for Federal intervention to save the city and the billions of dollars lost in the destruction.
During the last year, we have witnessed an eerily similar storm hit, this time on our economy in the form of a housing, mortgage, and credit crisis. Banks have written down massive losses and sought outside funding to recapitalize their balance sheets. Last week the storm took another turn with the Federal Reserve announcing their 75 basis point emergency rate cut.
With the FOMC's next scheduled meeting beginning today, two major questions remain unanswered:
- Why did the Fed enact an emergency rate cut this past week with the regular Fed meeting only a week away?
- What will the Fed do in light of last week's emergency rate cut?
While some market watchers would point to the rate cut as resulting from the rogue French trader who cost Societe Generale more than $7 billion, I would argue otherwise.
The Fed most likely saw the light bulb flash on, and changed their stance from thinking 'Things are not so bad and we are not in a recession yet' to a more forward looking stance, with a realization of the potential unfolding of events going forward. They finally succumbed to weakening conditions in global markets as the market began to expect an emergency rate cut. I believe Bernanke & Co already had agreed on the necessity for at least a 75 point basis cut at the next meeting, so they decided to do a "two-step" and get the first 75 basis point cut out into the market with no real reason to wait.
Returning to the analogy of comparing the current crisis with the Katrina crisis, the Fed was beginning to see the "financial levee" system, in this case, the bond insurance companies Ambac Financial Group (ABK) and MBIA (NYSE:MBI), crack due to the "Mortgage / Credit Crisis Hurricane." Barclays Capital reported Friday that banks may need another $143 billion in reserves if municipal bonds wind-up being downgraded. The quality of bonds worth $2.4 trillion is now in question. If ratings are cut one level from AAA to AA, banks will need to raise a minimum of $22 billion. If the ratings fall two levels to A, six times as much capital will be needed -- the financial levee collapses.
The financial levee system is currently breaking. Banks will repeat the same write-downs and need the same capital infusion as we have witnessed since early November, essentially knocking off another 10% - 15% of the S&P 500's earnings.
Bernanke was attempting not to alarm the market with an emergency rate cut, and this is why he waited so long to act. The Fed's inaction in the face of his blunt statements to Congress was having an unmistakably negative effect on global markets. Over the last several weeks, the market seemed to have a better handle of the situation with the economy and the rapidly evaporating business confidence, than the Fed. In order to restore the banking system, the Fed, in cooperation with the government, must enact a three-pronged approach: heal the banks, save the two bond insurers, and provide a fiscal stimulus package.
There is tremendous short-term pressure on our financial system (think of the levees). If those protection systems fail, the damage will be far worse. The President's number one priority should be to aid our financial system and help our banks become solvent. Banks must be put in a position where they become very profitable and can reestablish their capital base. Margins would then improve by borrowing low cost funds (the fed funds rate), and lending at higher rates. Although it will take time, the banks will heal themselves. The two bond insurers, Ambac Financial Group & MBIA, must be saved. This is a tough choice for banks. They can either put up cash now to save the bond insurers or suffer the wrath of write-downs and the need to raise additional capital as with the write-down of municipal bonds. The fiscal stimulus package announced by Washington last week should help as well. Proposed actions on the mortgage front essentially allow government sponsored agencies to assume bigger loans and reduce the pressure on the financial system – especially for jumbo loans and those seeking to refinance.
Given the 75 basis point cut last week, we would be surprised to see the Fed cut only 25 basis points this week. In fact, with Fed funds futures expecting a 70% chance of a 50 basis point cut, most market participants will be disappointed with a less commanding moderate cut and we could see a market response much like we saw in December.
I hope the Fed understands at this point that Fed funds need to be south of 3 percent. Let's hope the financial levee system doesn't break during this "storm." Bernanke doesn't want our banking system to go into a "Financial Accelerator," and his taking the decisive action of moving rates there sooner rather than later, will help contain the damage.