Mortgages, Ratings and CPI -- Oh, My

Jan Hatzius, the head economic honcho at Goldman, had some dismal forecasts the other day. He figures that home prices are going to drop another 10% this year, and that would mean 15 million mortgages -- or 30% of total mortgages -- would be on homes where the owner had "negative equity" in the house. I hope he's wrong, and I think he might be.

The number of applications for refinancing of mortgages has tripled in the last four weeks, which means that lower interest rates are starting to help. M2, a broad measurement of money in the system, is up $130 billion the last three weeks. This can be convoluted to explain, but accept that the Fed is pumping money into the economy, and it seems to be welcomed. Let's see how this plays out.

I read in the paper the other day that BBB-rated collateralized debt obligations (CDOs), which are collections of subprime mortgages, are 10 times more likely to default than BBB-rated corporate bonds. Moody's Rating Agency says no, no. They are only 8 times more likely to default (Saturday's Wall Street Journal.) What gives? What are the alleged rating agencies up to? Are they totally incompetent, corrupt, or what? How can you give something 8-10 times more likely to default the same rating? Enraging!

With the backup of leveraged loans on bank balance sheets, financial M&A is not likely to come back anytime soon. Those heavy loans will have to be moved to clear the way for lending activity to resume. The only way to move them would be to sell at a loss, which estimates figure to be 5%-7%. The banks can keep them and probably will get all the money back at maturity, but then they won't be able to make new loans. With $1.6 trillion in cash on corporate balance sheets, however, expect a lot more of strategic M&A, like the Microsoft (MSFT - commentary - Cramer's Take) bid for Yahoo! (YHOO - commentary - Cramer's Take).

The consumer price index was just released, and it was "hotter" than expectations at +0.4 percentage points on the headline and +0.3 percentage points on the core, which excludes food and energy. Year over year, the headline is +4.3%; the recent high was in 2005 at +4.7%. The core year over year was +2.5%, stronger than the 2% upper end of the Fed's target.

Before we get too excited, remember that inflation is a lagging indicator; before we start with doom-type forecasts of "stagflation," remember that the stagflation of the late 1970s and early 1980s had both inflation and unemployment in the double digits. The numbers released today, along with oil near $100, will cause the market to sell off. I still think we need to test the January lows of around 11,600 on the Dow vs. 13,400 now.

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Vincent Farrell Jr. is a principal of Scotsman Capital Management. Prior to joining Scotsman in April 2005, Farrell was chairman of Victory Capital Management of Cleveland and chairman of Victory SBSF Capital Management in New York. He was a founding partner of Spears Benzak Salomon & Farrell, which was acquired by KeyCorp in 1995. Vince held a variety of positions in his 23 years at SBSF, including chief investment officer, and he served as the portfolio manager on a number of the firm's largest client relationships. He is a regular guest on CNBC as well as other national print and broadcast media.

Prior to joining SBSF, Vince spent nine years at Smith Barney as a vice president, sales.

Vince graduated from Princeton University in 1969 and received his MBA from the Iona College Graduate School of Business in 1972.