I like writing about the Federal Reserve because I understand it well, but this is beginning to make me tired. Here goes:

1. There are some who believe that the Fed will not cut rates soon. I half agree with them, because the Fed should not cut rates here. Let bad loans get their due punishment. That said, that ‘s not the way the Fed has acted for almost 80 years. Given that the Fed has to interact with politicians and businessmen, they are going to get a lot of negative feedback if they don’t loosen the fed funds rate. I general, the Fed caves to political pressure. This Fed is doing it now, but just in small steps, while they console themselves that they haven’t moved yet.
2. On the surface, not much happened with the reduction in the discount rate. But the real story boils down to a willingness of the Fed to accept classes of securities that previously they would not. This includes ABCP. Beyond that, the Fed is allowing several large banks to lend beyond prior limits to their securities affiliates. This allows the banks to lever up more, and in relatively risky business. I am waiting to hear of charges of favoritism; failing that, of irresponsibility of the Fed in overseeing bank solvency of some of the largest banks.
3. The actions that the Fed takes now will shape the next financial crisis. Where it loosens, leverage will flow to healthy areas that can absorb it until they become glutted as well.
4. US T-bills have righted themselves, but i was surprised to see that Canadian T-bills went through a similar mishap. Oh well, they had ABCP also.
5. SIVs are one issuer of ABCP, and many of them are doing badly now. I would not be too quick to rescue them, or be too optimistic about their ability to make good a maturity. The assets in the SIVs that have gone bad are not likely to turn around quickly. Next cycle, we will be more careful about what we lend against, until we commit the same error in a new way.

I hope the Fed’s actions so far will be enough, but I believe that they will have to do more.

1. In commercial real estate, operators that are willing to “feed their properties” during bad times get respect, and sometimes even lower financing costs from those who lend to them.  In a similar vein, and perhaps it is making a virtue out of necessity, it was interesting to see KKR offer to pump money into their specialty finance affiliate.  Don’t get me wrong, they haven’t become altruists, but a longer-term orientation is refreshing, perhaps.
2. Arb spreads remain wide on deals though they have come back significantly recently.  For a gauge of that, simply look at a graph of the Merger Fund.
3. Who can get out of what?  Well, private equity [PE] got the Home Depot board to cave in to a lower offer.  Guess they needed the money.  But what of other private equity deals?  I suspect more will lower prices as well, but not all of them; some deals will break up.  But what of the banks committed to lending money on deals?  Many of them are doing all they can to get off the hook, but so many banks surrendered their flexibility to exit deals in order to get the business during the boom phase.  Now they are paying for it, or, at least, considering paying for it, since losses look like they will be 10-12% of the amount loaned, as they sell the loans to institutional investors.
4. “There is pressure to deploy,” said Ilan Nissan of law firm O’Melveny & Myers. “This business is about using resources to buy and sell companies. No one is making money by holding.“  To me, that what’s wrong with private equity.  If PE is just a larger version of condo-flippers, it has little reason to exist.  Improving operations and marketing would be far better things to do.
5. Somewhat off-topic, back to the Fed Model, since that deals with the tradeoff of debt for equity, much like PE firms do.  I felt that Dr. Hussman’s methods were mistaken, and so I commented over at A Dash of Insight:Even though his regression fit well, there were two things amiss. One, how many models did he try before he published his model? Did he do a specification search? When I did my model, I did only two passes over the data, and the first was accidental because I didn’t have a lengthy corporate yield series. The Moody’s series is one of the few that goes back a long way, and Bloomberg did not carry it. I wanted to use BBB corporates from the start, but could not find a series, so I did one pass with Treasuries.

   http://alephblog.com/2007/07/09/the-fed-model/

   Second, after doing the analysis, the rest of his results rely on an extrapolation from the recent past to the further past. Dr. Hussman is the one who argues that the 80s are unique, but that is a large part of the data that he uses to estimate his backcast. No matter how good the fit, it is not safe to do extrapolations. Too many structural things change over time in capitalist economies.
   

That’s all for now.  I might have the strength for one more post tonight.

Tickers mentioned: KFN HD