Subprime Lenders Up on Hope Fed's Done

This column was originally published on RealMoney on Sept. 1 at 3:06 p.m. EDT. It's being republished as a bonus for TheStreet.com readers.

Financial speculators are beating their tom-toms with special enthusiasm today over the possibility that the unexpectedly harsh effects of Hurricane Katrina will lead the Federal Reserve to pause its campaign of hiking interest rates.

In an interview on CNBC, portfolio manager Paul McCulley, who helps Bill Gross steer tens of billions of dollars worth of bond bets at Pimco, called Fed action "finished."

Traders took that cue and dived right in to one of the sectors of the market most badly burned by the prospect of higher rates -- the subprime and nonconforming mortgage lenders -- and started driving up shares. Aames Investment(AIC Quote), a subprime home lender based in Los Angeles that saw its stock cut by a third in August, is rebounding as much as 3% today. Likewise, shares of subprime or nonconforming loan issuers Accredited Home Lending(LEND Quote) of San Diego and NovaStar Financial(NFI Quote) of Kansas City are each up better than 3%.

These moves could all have legs if Katrina does in fact lead the Fed to take a wait-and-see attitude toward the U.S. economic recovery at its September meeting. But it's not a sure thing, of course. Here's one way to think about it, courtesy of veteran Fed watcher Tom Gallagher, analyst at ISI Group in Washington D.C.

• Start with consideration of the growth impact of Katrina. First, you have a vast loss of income and wealth in the Mississippi-Louisiana area that will be offset only partly by rebuilding, government aid and insurance payments. Then you have the impact on the energy and transportation systems, which are an unmitigated negative shock. Consumer demand nationwide had been a big concern pre-Katrina, but now you also have much higher gas prices and a couple of major cities -- New Orleans and Biloxi -- out of commission for months. (That's much different than your basic Florida hurricane, Gallagher notes, where damage is localized, and people are usually back at work quickly.) Net net, growth is a negative.

• Next the Fed considers inflation. The supply shock lifts prices, while the demand shock restrains them, Gallagher says. Figure it's a net neutral.

• Then there's an impact on the financial system. Banking operations in the area have broken down, and shares of local financial services companies like IberiaBank(IBKC Quote) are sinking. Over the coming weeks, Gallagher, forecasts, there will likely be a growing number of defaults on consumer, mortgage and business loans. Not good.

While the knee-jerk reaction is to consider the economic impact will be negative, the Fed will probably wish to be more circumspect. If the Federal Open Market Committee were to meet in the next couple of days, Gallagher said, it would likely pause simply because it won't know the magnitude of the demand, supply and financial impacts. But because it actually meets three weeks from now, it has time to assess the damage with more perspective.

So Gallagher's final guess on the probability of Fed moves goes like this:

• It probably will hike again in three weeks, but let hurricane damage affect its endpoint. It could accomplish that with a statement to that effect following its meeting. He says the Fed has a high threshold for a pause, and may be concerned that one pause would lead the market to assume it is done for the cycle.

• Or it could start an "extended pause" in September. The reasoning could be that this extreme hurricane's damage does meet the threshold for a halt in hikes, considering the moonshot in oil prices will have the same effect on the economy as it is trying to accomplish anyway.