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ECONOMIC ANALYSIS:

Thinking About Cuts

by Fred Cederholm

The rate cut stole the headlines, but it was the FED’s almost clandestine increase in repurchase agreements (REPOs) with financial institutions last week that should have really sounded the alarms.
I'e been thinking about cuts. Actually I’ve been thinking about Sub-prime/AltA mortgages, interest rates, return-on-investments, currencies, REPO’s, terminations, and job creation. If you divide last week’s quarter point interest rate cut by the Federal Reserve Bank’s benchmark 4.75% (rate before the cut), you get a decrease in that effective rate by 5.26%. While this may seem an overly simplistic way to predict the impact of the FED’s cut, bear in mind that the prices of crude oil and precious metals jumped almost immediately by that percentage. I suspect that the Dollar will shortly further erode against the world’s basket of primary free floating currencies by a similar percentage.

You see the sub-prime/AltA mortgage crisis has not left us. If anything, the implications and ramifications of this lending debacle run amok are only beginning to surface in more sectors than were identified as earlier areas of concern. Investments were traditionally valued based upon their projected future cash flows, or proceeds. Such cash flows were at the core of the return-on-investments (ROI) used in determining the valuation, pricing or carrying value of investment vehicles. If the ROI was cut, this would negatively impact the valuation of the investments and price/valuation would drop accordingly.

The valuations of currencies as an investment vehicle – money itself held as an asset – work in the same manner. There is a (holding) time value to money, and that is called interest. When interest rates are cut, there is, by this definition, a re-evaluation of the valuation of the respective currency downward and its purchasing power declines. We saw this last week as the price increased on petroleum and metals. We shall see such trends continue in the equity/stock markets for those investments denominated in dollars. The rate cut was “marketed” to the public as a solution/fix to the mortgage mess. Rate cuts pricing interest “costs to borrowers” below the actual inflation rate created this bubble crisis in the first place. Returning to similar logic/policy as the solution/fix will only worsen things.

The rate cut stole the headlines, but it was the FED’s almost clandestine increase in repurchase agreements (REPOs) with financial institutions last week that should have really sounded the alarms. The FED can temporarily increase liquidity (amount of cash available for new lending) by “buying” investments from banks in the short term – with the understanding that the “selling” institution will buy them back at a predetermined date. Until August such REPO’s were limited to US Treasury Securities and the highest rated levels of commercial paper (corporate bonds). In August the FED began accepting the sub-prime mortgage backed securities known as CDOs. This should have been a red flag telling us that the FED had to accept these mongrels because no one else would! The crisis was worse than stated.

Last Thursday, the Fed conducted $8 BILLION of 14-day repurchases, $21 BILLION of seven-day repurchases and $12 BILLION of overnight repurchase agreements. The total exceeded the $38 BILLION which the Fed injected last Aug. 10, at the beginning of this global credit crisis. This was done to alleviate strains in short-term lending markets worldwide. To put it in perspective, this was the largest such single day infusion since the FED injected $50.35 BILLION on Sept. 19th, 2001 following the Sept. 11th, attacks on the World Trade Center and the Pentagon - making this a threat “equal” to the terrorism?

Mega BILLION crises (of write-offs) just forced ousters of chief executives Charles Prince at Citi-Bank and Stan O’Neill at Merrill Lynch. Chrysler announced job cuts of 12,000 – 1,000 of which at the Belvedere’ plant about 40 miles from my home. Not to worry, the Labor Dept. just announced how 130,000 new jobs were “created.” They didn’t mention that 103,000 of those – 14,000 in construction and 25,000 in financial services – were hypothetically generated by statistical models. It’s not that they are not out there, they just can’t specifically be identified and located! Didn’t we hear THAT justification before in some other context???

I’m Fred Cederholm and I’ve been thinking. You should be thinking, too.


Copyright 2007 Questions, Inc. All rights reserved. Fred Cederholm is a CPA/CFE, a forensic accountant, and writer. He is a graduate of the University of Illinois (B.A., M.A. and M.A.S.). He can be reached at asklet@rochelle.net.


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This story was published on November 5, 2007.