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EScroogeJr (< 20)

Fool's rally? Probably not.

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August 17, 2007 – Comments (4)

Markets always go up when the Fed announces a rate cut in response to some real or imaginary economic problem. Usually, such rallies peter out soon because people eventually realize that an economy with a problem that the Fed is trying to fix must be in a worse shape than an economy that functions without problems and without rate cuts. So is today's just such a fool's rally?

My take is that this rally is for real. The reason is that the economy is in an exellent shape, and housing prices are quetly rising. The subprime worries cannot change the trend for two reasons: first, subprime borrowers will not reduce the demand because they have been priced out of the market since after 2004 anyway, and secondly, because this year's price increases will justify all those who used ARMs to buy houses during what will be seen in hindsight as the early stage of the rally, and all those who provided financing for them, with the exception of a tiny percentage of people who have stretched themselves too thin to wait through 2007. This is not the dot-com bubble burst, when the lowering of the rates was merely an indicator that things had really got out of control. Instead, this rate cut was both a response to, and a solution of, the very trivial problem that emerged on the horizon.

Here is what actually happened: so staggering were the prospective profits from the appreciation of real estate that all lenders leveraged themselves to the maximum, and some overleveraged themselves. But there was a reason they went so out of their way: they calculated that houses were set to double from their 2005 prices, which would make their ARM loans perfectly safe, which in turn would mean enormous returns for them as they borrowed money at 5% to charge borrowers 7% after the ARMs adjust. Inevitably, some bit more than they could chew, just like those shorts in 1998 who correctly called the bubble burst but leveraged themselves too much to survive one year of market irrationality in 1999. So some smaller players went belly up, and the large ones are now about to achieve their objectives with a little help from the government.

Contrast that with the drama of 2000. There there was a real bubble, where people invested several trillions of dollars into an asset whose fair value was zero. Its fair value was zero because companies like pets.com never made a penny of profits, so aside from playing the greater fool game, there never was and never will be a reason to own shares in them. When the bubble burst, it was too late for the Fed to save the day. Trillions of dollars were lost, and economies don't survive such losses lightly. The news of rate cuts was like the news that the patient was given a tylenol pill after breaking a leg, and therefore it could not reassure the markets.

In this current credit crunch, people invested trillions of dollars into mortgage securities backed by a very real asset: construction lots. This is entirely different from pets.com. An asset like this will always be in high demand. When the underlying reasoning was sound, a little cash infusion can help all but the most overleveraged investors remain solvent. So this time the Fed has not reacted to the problem; it has solved the problem. We will go into recession some day, but not tomorrow and not because of the credit crunch. 

So it looks like today's events will indeed mark the end of this 10% corection. It's a real pity that this correction was already curtailed some 4 percentage points in just two trading days. And yet, it can be said with respect to many stocks, especially homebuilders and construction material suppliers, that Mr. Market is still reasonably generous to us.

4 Comments – Post Your Own

#1) On August 17, 2007 at 10:45 PM, retailsails (94.68) wrote:

Not sure where you're getting your information from but house prices have been falling steadily every month in 80% of the country and show no signs of slowing down, many of those mortgage bonds you speak of will be worth ZERO and banks, insurance companies, and hedge funds own hundreds of billions of them.  What the fed did today means absolutely nothing except as a "feel-good" story, and won't help the mortgage lenders, home builders, and investment banks who have real problems...if you think the dot-com bubble was bad you just wait...

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#2) On August 17, 2007 at 11:05 PM, EScroogeJr (< 20) wrote:

"What the fed did today means absolutely nothing except as a "feel-good" story"

How's that? The cost of money means nothing to lenders? In an industry that is centered around exploring "tiny" spread differences on the order of 1%? Hilarious.

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#3) On August 18, 2007 at 5:02 AM, SpecBear (97.71) wrote:


If the subprime buyer has been priced out since 2004, then why were there still subprime loans being used for purchases in 2006?

A bubble isn't about people investing in something that's worthless, it's about the price of an asset being inflated far beyond what the fundamentals support.  So it doesn't matter that mortgages are backed something with real value for which there will always be demand if the price paid was too high.

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#4) On August 18, 2007 at 10:23 AM, EScroogeJr (< 20) wrote:

And what is your definition of too high?  How much would someone be willing to pay for a house, having no alternative and knowing that he can't survive without one? Look at it in this light, and today's price of 7 annual pretax incomes will seem very, very cheap.  Can you rent it for less? Yes, if you believe that your rental rates will always stay at today's levels. No, if you choose to be realistic.

 

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