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When rain falls on a parched desert, long-dormant seeds spring to life, a thousand flowers blossom overnight, dunes are adorned with a lush and verdant carpet of vegetation, dry stream beds awake as burbling brooks...So too, when the Fed lowers rates - thrifts, mortgage companies, investment banks, conduits, homebuilders, financial guarantors - all will flower anew - a mighty flood of liquidity will wash across the parched economic landscape. The river of mortgage payments, which only yesterday ran dry, will spring back to life. Torrents of cash will flow down the waterfalls, drenching the equity tranches...
Perhaps the overall effect will not be that dramatic. Anyway, to predict which stock in my portfolio would immediately respond best to a rate cut, I can look at what happened on 8/16-17, as the market plunged and then rallied after the Fed cut the discount rate. MBIA Inc (MBI), a financial guaranty insurer, traded as low as 50.45 on Thursday 8/16, and closed at 63.60 on Friday 8/17, the date of the announcement - a 25% gain overnight. It has since been slowly surrendering its gains.
MBI insures securities backed by sub-prime mortgages against default, and also holds them in its investment portfolio. As I discussed in my blog when I added the stock to my SLO portfolio, based on their presentations and disclosures I don't believe they will suffer serious losses due to the sub-prime debacle.
However, the underwriting and credit analysis for these instruments is complex and relies on models which may perform poorly when credit markets are subjected to extreme stress. While MBI representatives genuinely believe that a worst case scenario would not subject their employer to material adverse results on either its insured or investment portfolios, the market seems to be pricing in a possibility that MBI could suffer crushing losses in a melt-down of sub-prime mortgage backed securities.
Looking at the sub-prime crisis as it affects the economy and our financial system, the common sense conclusion is that the safest course for the Fed will be to ease credit in order to prevent a worsening of the crisis. This will result in bailing out many participants in the sub-prime fiasco. If the Fed acts as expected, the perceived risk to MBI would diminish markedly, because it requires a cataclysmic downturn, something totally beyond what they have reflected in their models, to cause serious harm.
Based on this line the thinking, once the Fed starts the rescue operation, MBI would go up substantially during the days following the rate cut announcement, repeating its performance of 8/17.
Looking several quarters down the road, it is harder to predict the timing of the long-term effects of a rate cut, or series of rate cuts. Investors will be attempting to rotate into the sectors most likely to be affected, and many will be looking for a recovery in homebuilders, banks and finance companies, or building supplies. I follow a selection of homebuilders and own them in my personal portfolio. I plan to add some to my SLO portfolio, feeling for the bottom, primarily based on the fact they are trading in the general area of 1x book value.
Dividend payers generally should do well as dividends will be more attractive in a lower rate environment. With 10 out of 11 stocks in my portfolio paying dividends, that should help me. All stocks in the interest rate sensitive Financials sector should benefit, including Cincinnati Financial (CINF) and Chubb (CB), both insurance companies included in my SLO portfolio. Concerns about possible losses on mortgage backed securities have been depressing their shares, which should cause them to rally as fears are reduced by the rate cut.
On a case by case basis, companies with excessive debt loads or liquidity issues might make impressive gains. Companies generally considered as buyout targets might start trading at a premium again, particularly if they become the subject of rumors or speculation.
I expect MBI to also perform well in the quarters following a rate cut, assuming a recession is avoided or contained. Their quarterly earnings will be carefully watched, for either mark-to-market losses on their investment portfolio or case reserves on their insured portfolio. If they avoid major losses, the stock should rally after each report. Under a best-case scenario, chastened investors will be unwilling to accept credit default risk without being adequately compensated. MBI will then prosper as risk aversion creates expanding demand for their guarantees and improved pricing power. With a combination of revenue growth and margin improvements, EPS and the P/E multiple would expand together, increasing share prices accordingly. I am looking for 75, which would be a 50% gain from the lowest of my 3 buys.
Actually I am not that confident that an immediate rate cut or series of cuts will solve all the problems. The way I remember the last time real estate went down, a lot of banks had to be closed or merged, taxpayers picked up the tab, many homeowners struggled for years with mortgages they could not handle and condominiums decreased as much as 50%, leaving many good faith buyers with no equity. Commercial real estate got involved due to overbuilding. It took years to muddle through it. At this point, securitization has been discredited, and a rate cut or two is not going to restore the willing suspension of disbelief required to pick up where the party ended. Also, when a ship is sinking it is every rat for himself. I am sure that some relationships were damaged while panic swept the markets, and it will take time to rebuild trust and get things flowing smoothly again.
With that in mind, I will enjoy any gains arising from a rate cut, but I will not be making major changes to my portfolio in anticipation.
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