Subprime Mess: Is that a Mushroom Cloud in the Distance?

If you are like me you are having a difficult time getting your arms around the subprime crisis. I am not sure how bad it is; what it is going to do to me; and what action I should take, if any? I hear all of the problems in the news, but, as of yet, it hasn't affected me. Finally, I after much agnst I came up with an anology that helps me visualize the situation and how I should react.

Picture yourself standing outside your home. Fifty miles away, in the distance, you see a mushroom cloud from a nuclear blast rising into the atmosphere. Once you get over the initial shock you realize that it is far away from you. In fact, the sun is shining and everyone is going about their business.

The second thought that comes to your mind is: "I wonder which way the wind is blowing?" Is the nuclear fallout coming towards me or away? How bad is it going to be? For those individuals at ground zero it is pretty bad!

I visualize the subprime mess as a nuclear bomb that has exploded in our financal system. Personally, I don't have any direct contact with industries affected by the crisis. The sun is still shining on my business and we are making money. But I am keeping an eye on that mushroom cloud in the distance! I know that as it spreads through the economy some fallout will affect me. In the meantime, we are spending causiously, hiring selectively and marketing aggressively.

The Fed forestalls the inevitable

The Federal Open Market Committee announced prior to today's market open that it had lowered its federal funds target by three-quarters of a percent, or 75 basis points, to 3.50%.

This certainly feels like the house extending a drunk casino patron more credit after they've already burned through their last two extensions.

Anyways, naturally the dollar continues its slide, though no matter how low it goes, it's still cheaper to manufacture products in China or provide services in India. One also has to wonder how long the Chinese will continue to subsidize the United States with its willingness to plow the dollars sent its way back into US government debt, thereby helping to keep interest rates low. For how long will the Chinese government be able or willing to continue this arrangement? Yes, it has brought tremendous growth to the Chinese economy, but at some point one would have to think that the Chinese people will have had enough of the fruits of their labor not being reinvested in their own homeland.

The American consumer now stands on the precipice. Saddled by debt, their home values in decline, and now their equity market wealth slowly disappearing. Not to mention that the vast majority of their assets are in...dollars.

It's also interesting to note that the Fed seems almost entirely focused on making life easier for Wall Street. Of course, given that Main Street's fortunes are so closely tied to it, perhaps it's not that surprising.

If They Will Buy Then I Will Sell!

Or stated another way, if I can sell it then buyer beware! That seems to have been the motto for the sub prime mortgage industry. Over the past five years a looming crisis has been in the making. Mortgage brokers would originate the loan then immediately pass on the risk to the investors. Few would keep the loans for a month let alone ninety days. Consequently, they were assuming little risk and had no incentive to police the quality of the loan.

Some people are questioning whose responsibility it was to police the market. At some point in the cycle someone needed to say no to the level of risk being assumed. Some say we should have government oversight. I say it is the job of Mr. Market!

The only thing that keeps people from taking stupid risks is the fear of loss. Until recently we haven't had that in the past five years. During this time period we have experienced low cost of capital, high liquidity and increasing productivity of employees. Now the market forces (i.e. losses) are policing the sub prime markets.

The real question is what other markets in the economy are in line to be disciplined? The economy is beginning to look like a slow moving train wreck. This scenario is not unlike the dot com bust where few of us were directly in the business but all of us were effected. Now is the time for entrepreneurs and their CFOs to take action to weather any possible storm.

Fed Lowers Rate Target. Time to Pop the Cork?

Yesterday afternoon, the Federal Open Market Committee did what was not expected, if you paid any attention to published reports, yet what was already priced in by the futures markets and lowered its target for the federal funds rate by 50 basis points to 4.75%. While US equity markets reacted favorably to the news, with the Dow Jones Industrial Average, Nasdaq Composite, and S&P 500 indices all up on the news today, it is unclear as to whether this is a sign of good things to come, as the equity market reaction seems to suggest, or merely an attempt to forestall an inevitable slowdown of the US economy. The Fed, for its part, couched its change as a response to the current troubles which have hit the credit markets, in particular mortgage lending:

"Economic growth was moderate during the first half of the year, but the tightening of credit conditions has the potential to intensify the housing correction and to restrain economic growth more generally. Today’s action is intended to help forestall some of the adverse effects on the broader economy that might otherwise arise from the disruptions in financial markets and to promote moderate growth over time."

FOMC Statement September 18, 2007

It certainly seems that the Fed is responding to pressure from the financial community to ease its monetary policy in the face of increasing difficulties in the credit markets in general, as well as to perhaps throw those who recently financed their purchase of a home with an adjustable rate mortgage a bone. Needless to say, this is probably not good news for the US dollar, which continues to depreciate in value relative to other major currencies. One does get the feeling after reading the FOMC statement that we may be headed deeper into a rough patch.