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August 13, 2007

Whats Next and Why I Like Cool
by Charles Zentay

After a couple weeks of volatility in the markets, many investors have begun to ask themselves: "What's next?"

Will the market slide further? Will the economy be affected? Or are investors panicing without reason, and is the market ready to resume its upward march?

A central focus within these questions - as always - is: "What will the Fed do?"

Let's take the last question first.

Anyone who becomes Chairman of the Federal Reserve is very astute at understanding power structures and who pulls what levers to help someone get to the top. I am 100% sure that Ben Bernanke is aware that the next President of the United States will be the person to decide whether he gets nominated to a second term or not. According to the polls and common sense, that President is most likely to be a Democrat and most likely to be Hilary Clinton.

Everyone on Wall Street expects the Fed to act very quickly to lower rates to help the banking system. Before reaching such a conclusion, isn't it helpful to ask: "Do you really think Hilary Clinton would mind a recession leading up to her presidentail campaign?"

Plagued by the Iraq War AND a recession, would the Republicans have a chance? Wouldn't she actually be very appreciative of a "responsible" Fed chairman who helped induce a mild recession?

Another fact is history. Greenspan spent 18 years encouraging credit growth. That credit growth expanded to ludicrous and dangerous proportions.

Recently, people with bad credit histories who could not qualify to rent a house could easily qualify to buy it! With no money down. The next day after bankruptcy, borrowers could get low interest rates and lots of money. Worse still, many other loans had floating rates, which meant that if interest rates rose (which they did) the homeowners were unlikely to be able to afford their houses in 2 years time. Well, 2 years time is starting to be up for many of these loans, and guess what? Default rates are skyrocketing! Interestingly, late into his tenure, Greenspan actually spoke out in favor of floating rate loans, encouraging more Americans to take them.

Like the dot-com bubble before it, this mortgage bubble is exposing a lot of dubious assumptions and fraud. Given that the Federal Reserve lowered rates to historically low levels during the beginning of this bubble (thereby encouraging it) and neither did nor said anything to prevent it, there is clearly some responsibility that lies in the hands of the Fed. For history's sake, Bernanke does not want anything to do with this mess. He will want to be strong and show that he is not easily persuaded into lowering rates just to bail out the banks and mortgage brokers who acted irresponsibly. Bailing them out might encourage even more irresponsible behaviour in the future and lead to an even greater bubble.

So, because of the Clinton factor and the history factor, Bernanke might be slower or at least more reluctant to come to the rescue than many market watchers are expecting.

That said, once a President nominates the Fed Chairman for another term, the nomination must be approved by Congress. If Bernanke sends the u.s. economy into too deep a recession, he runs the risk of alientating the public to such a degree that no Congressperson will be able to support his nomination.

Therefore, I expect the Fed to lower rates but in a very tempered fashion.

So, what does a tempered Fed mean for the financial world and the economy?

My conclusion is that the lending market will slow.

Banks have been selling CDOs and other CLOs and other fancy products to insurers, pension funds, and foreign banks for the last several years. Those products are now experiencing much higher rates of default than the banks led their clients to believe. As a result, these clients are highly unlikely to accept new products, even with lower interest rates. With the end of excessive lending, look for the housing market to continue to decelerate, with most markets seeing serious price declines. Look for the LBO market to dimiss and asset prices to come down. Most important, look for any company that has lots of debt and weak cash flow (a lot of the companies that have been LBOed) to be in serious trouble. Look for the banks to use the lower interest rates from the Fed to shore up their balance sheets and increase spreads.

But I do not think the banks will have the audacity or willing clients to pass along the benefits of lower rates via newly-conceived "financially-innovative products."

As a result, it is likely the U.S. economy will continue to slow. Without the "juice" from excessive lending, consumers will pull back and consumer-oriented companies geared towards U.S. consumers will experience less growth. The ripple effects will be felt to some degree by many U.S. industries.

At the same time, the strong global economy should provide some level of relief. With new consumers in India, China and myriad other parts of the world, other countries may be able to compensate for slackening U.S. consumption.

Looked at from a different perspective, the U.S. might have to rely less on "financial innovation" and more on good, old-fashioned manufacturing for its next stage of growth.

If such a scenario unfolds as outlined above, the most important conclusion for investors is: "Don't be leveraged!" For years, there has been a strong benefit to being leveraged. Entire industries (private equity, mortgage brokers) have grown out of this idea.

Now, the world might turn on its head. In both one's personal finances as well as one's investments, less might be more. The sages of wall street seem to have forgotten: "Less leverage means more upside in a downwardly moving market." It's a concept that's very out of fashion.

But this time, by being unfashionable, by the end of the night you might be the coolest kid at the party.

I like cool.

Charles Zentay
thinkinvest.blogspot.com

Charles Zentay is an independent business person who monitors the financial markets very closely.  Visit his blog at thinkinvest.blogspot.com.

Copyright © 2007 Charles Zentay

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