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Subprime's Salvation Is Fed's Conundrum

Liz Rappaport

The hedge fund Farallon rescued Accredited Home Lending(LEND - Cramer's Take - Stockpickr) Tuesday but may have blown up some bulls' rate cut thesis in the process.

Why would subprime lenders need an injection of new liquidity from the Federal Reserve when there's enough out there to facilitate a hedge fund rescuing a subprime lender? The Fed is unlikely to cut the fed funds rate or change its bias at the conclusion of Wednesday's Federal Open Market Committee meeting because evidence of loose liquidity is still abundant in today's financial marketplace -- even with the subprime problems and house price deflation and, yes, even with slower economic growth.

But a Fed that stays on hold doesn't preclude the usual "Bernanke bump." Indeed, Todd Leone, head of listed trading at Cowen & Co., says the stock market's strength over the past couple of days is partially due to anticipation of Federal Reserve Chairman Ben Bernanke's effect.

"Bernanke has been very friendly to the Street," says Leone. "The last few times he spoke, the market has ripped. ... People are hoping they say something about easing ... some kind of easing hint."

Unlike his predecessor Alan Greenspan, who has lately spurred stock market swoons, Bernanke has rarely disappointed the market since the Fed stopped raising the fed funds rate last July. The Chairman soothed markets the day after the Feb. 27 rout. Prior to that, Bernanke's semiannual testimony to Congress in mid-February gave stocks a Valentine's Day gift that catapulted the market to its Feb. 20 highs.

The markets continued to rally Tuesday, and the S&P 500 closed above both its March 9 intraday high and March 12 closing high, which is a bullish technical sign. The S&P 500 closed up 0.6% at 1410.94 while the Dow Jones Industrial Average finished up 0.5% to close at 12,288.10. The Nasdaq Composite closed up 0.6% at 2408.21.

Farallon's loan to Accredited is just one of many examples of trades and investments founded on the idea that liquidity isn't drying up. The $30 billion worth of M&A deals announced in the first two days of this week are another example.

Tuesday was almost as robust as merger Monday:

Claire's Stores(CLE - Cramer's Take - Stockpickr) jumped 3.6% on news that Apollo will take the company private in a $3 billion deal. Cerberus Capital joined with Affiliated Computer Services'(ACS - Cramer's Take - Stockpickr) chairman in a $5.9 billion bid to take the company private, sending it up 16.9% on the day.

Meanwhile, handheld technology company Palm(PALM - Cramer's Take - Stockpickr) gained 3.5% on a news of a possible buyout.

Motorola (MOT - Cramer's Take - Stockpickr) rallied 2.9% after CEO Ed Zander canceled a scheduled appearance at a wireless conference, spurring speculation that either a deal or a change in Motorola's executive suite is in the works.

Oracle(ORCL - Cramer's Take - Stockpickr) jumped 2.2% and was gaining more ground in postclose trading after the company reported strong third-quarter earnings. The profit surprise was largely due to unexpectedly strong license applications. If companies are spending more on software and information technology than analysts expected, it is a sign of a strong economy, not a weak one.

On the flipside, Halliburton(HAL - Cramer's Take - Stockpickr) gave lower first-quarter earnings guidance, sending its stock down 5.8%.

See No Credit Crunch

Similar to hedge funds that provided rescue loans to energy companies El Paso(EP - Cramer's Take - Stockpickr) and Williams Cos.(WMB - Cramer's Take - Stockpickr) in 2003, Farallon may be betting that its $200 million loan will help Accredited get through this subprime storm. It may think Accredited is one of the good eggs with solid assets behind it and that it'll be sold or come out the other end a decent company.

Maybe. But there is no question that Farallon, which gets 13% annual interest on the five-year loan plus a payment of 3.3 million in-the-money warrants, is partly banking on liquidity in the stock market to help its cause. On the warrants, which give Farallon the right to buy the stock at $10 per share, the hedge fund already made about $2.6 million, or 8%, just on Tuesday. That's the "in-the-money" part as the stock opened Tuesday over $10 per share and closed up 20.3% at $10.77. Volume was about five times its average as Accredited has become a day-trader favorite.

So "there is no evidence of any seizure of liquidity," says Michael Darda, chief economist at MKM Partners. "This narrow space [subprime] where risk was mispriced doesn't mean credit or liquidity is not available."

Spreads, or risk premiums, are also still tight in high-yield bonds. Commodity indices are recording new highs. Unit labor costs have hit a six-year high, and core inflation remains stubbornly above the Fed's so-called comfort zone. Likewise, industrial output is snapping back, and jobless claims are falling back to lower levels.

While traders want a rate cut and think it will help the market, a fed funds rate cut may only exacerbate inflation problems. "Liquidity does not come without inflation consequences," says Darda. Higher inflation certainly won't help the subprime borrowers suffering from higher loan payments or negative equity in their homes.

That said, the Fed is very aware that it must retain its credibility as being both thoughtful about economic concerns and vigilant on inflation, says Mickey Levy, chief economist at Bank of America.

Levy, like most economists, believes the Fed will keep its policy statement similar to recent offerings. "The Fed will give an honest read," says Levy. "They'll say the economy has softened a bit, but they'll maintain their upward risk assessment on inflation."

Any change in tone is likely to appear in the first or second paragraph of the statement -- where previous phrases have addressed changes in the economic outlook, such as "substantial cooling of the housing market" and "tentative signs of stabilization have appeared in the housing market." Don't expect the "boilerplate" language that has come at the end of every statement since last July's pause to go away:

The Committee judges that some inflation risks remain. The extent and timing of any additional firming that may be needed to address these risks will depend on the evolution of the outlook for both inflation and economic growth, as implied by incoming information.

In other words, the Fed will keep its tightening bias. But the markets will probably read it as dovish and rally anyway.