Remember this the next time you're trying to figure out the effects of the Federal Reserve's battle to keep the economy growing: There's no such thing as a free lunch.

By aggressively cutting interest rates, the Fed has kept this economy from sinking into a deep recession. Low rates have propped up consumer demand for everything from cars to houses. And that's been critical because the corporate side of the economy is stuck in what amounts to a capital-spending recession.

But the benefit of a relatively shallow recession, at least so far, comes with major costs. First, the Fed's massive intervention in the financial markets and its decision to pump up the money supply have led to serious distortions in the way the financial markets price risk. In both the bond and the stock markets, many prices don't adequately discount future risks right now. Second, the Fed's efforts to stave off a recession today raise the odds that the recovery tomorrow will be anemic. In effect, we've borrowed from future growth to keep the economy rolling in the present.

What California Bonds and Ford Bonds Have in Common

Let's take a hard look at prices and risk in today's bond and stock markets. I'll start with bonds.

Today you can buy a tax-exempt bond issued by the California Department of Water Resources that yields 4.82%. That's a pretty tempting rate on a bond that matures in 2008, if you've noticed that the 10-year Treasury note is yielding just 3.7% or so at the moment. It's even more tempting if you live in the high-tax state of California and can take full advantage of the bond's exemption from state taxes. So it's not really surprising that the price of this bond has increased 14% since it was issued just this month. In other words, a bond that originally yielded 5.5% and sold for $10,000 not so long ago, today costs $11,412 and pays just 4.82%.

That municipal bond has a lot in common with a bond issued by Ford Motor Credit, a unit of Ford Motor ( F), that matures around the same time, November 2008 to be exact. Like the California Water Resources bond, it now trades above its issue price, about 2.3% higher. And it now yields 6.24%, less than it paid when the bond was first issued.

But the major thing these two issues (one municipal and one corporate) have in common is that each price seems too high when you take a hard look at the risk hanging over each bond.

In the case of the California Department of Water Resources issue, Standard & Poor's has just put the bond on credit watch. California Gov. Gray Davis has asked the department to seek a $1 billion rate cut from the California Public Utilities Commission. That, S&P said, would withdraw substantial reserves from the department.

To get their 4.82% tax-exempt yield, investors are thus being asked to take on the risk that the department won't have enough revenue to support the bonds and to face the very real possibility that California's desperate politicians -- in their efforts to beg, borrow and shift revenue to patch over the state's huge budget deficit -- will do something stupid that will cost the department more revenue and lead to a further downgrade of California's statewide credit rating.

In the case of Ford Motor Credit bonds, for that extra 2.5 percentage points in interest above the yield of a 10-year Treasury, an investor gets to take on all the risks of Ford's income statement and balance sheet. In its most recent quarter, for example, the company reported that more than $1 billion flowed in the form of a dividend from Ford Motor Credit to Ford, the parent company.

In the first quarter of last year, the money flowed in the other direction. In the first quarter of 2003, Ford also booked a $367 million drop in its reserve for credit and insurance losses. Investors in Ford Motor Credit bonds clearly face the risk that the parent car company, with a gaping need for cash, will continue to milk the credit division, and at the same time lower the reserves available to cover the possibility that the folks who bought Ford cars on company credit won't pay their bills.

Bond Buyers go out on a Limb

I'd argue that in both of these cases investors are taking on more risk than they're getting paid for. For example, California faces a $38.2 billion budget gap over the next 14 months. That's up from an estimated gap of $35.6 billion just last January. So far the governor and legislature have been able to agree on just $14 billion in proposed spending cuts. And after seeing his original plan to raise taxes to fill the gap drown in a sea of bipartisan opposition, Gov. Davis has proposed a sleight-of-hand budget that relies on such "hidden" taxes as a $4.2 billion increase in car registration fees and issuing another $11 billion in bonds to be paid off over the next five to seven years by a half-penny increase in the sales tax.

Ford, for its part, was told not so long ago that bond buyers wouldn't buy any more unsecured debt because the company as a whole was too financially shaky. The Ford Motor Credit bonds are secured by car loans. Such secured bonds carry the risk that more borrowers than expected won't make their installment payments.

So why are bond investors willing to take on a high degree of risk for a relatively modest reward? Because the current policies of the Federal Reserve have, bond buyers believe, guaranteed them against the risks in these bonds. The bond market is interpreting the Fed's May 6 warning on the dangers of deflation as a commitment from Alan Greenspan and company to keep rates low for the foreseeable future. That means no interest rate increases even if the danger of potential inflation increases. The possibility that the Fed would raise interest rates to stage a pre-emptive strike at inflation before it even actually appears is off the table, bond investors believe.

And with the Federal Reserve promising to keep rates low and to keep goosing the money supply until the economy rebounds, the odds that either California or Ford will default on their obligations is insignificant. At least that's what the prices of these bonds say that the market believes.

Looking at Lucent

You can find the same kind of thinking about risk over on the stock side of the financial markets. Look at Lucent Technologies ( LU) for example. The shares are up a huge 88% to date in 2003 and an amazing 59% in the last month.

The only question in investors' minds seems to be: When will telecom spending pick up? Lucent's recent quarterly report showed profit running ahead of projections. The wireless division, potentially the restructured company's strongest unit, showed margins of 17%. With the Fed promising to lower rates again and expand the money supply to increase growth in the economy, the market seems to feel confident that the company is on the road to a successful recovery.

All this ignores the financial risks at the company. Another $300 million in cash flowed out the door in the most recent quarter, and if you read the company's 10Q filed with the Securities & Exchange Commission carefully, you'll note that Lucent now projects cash flow to slip by another $200 million or so in 2003, thanks to problems with the off-balance-sheet special trust the company set up to sell off vendor financing loans and receivables.

The rise in the stock also doesn't seem to reflect the huge off-balance-sheet liabilities represented by the company's pension plan. The company is carrying about $5 billion in retirement benefit costs on its books currently, and that's possibly as much as $5 billion too low.

And finally, there's the dilution that existing shareholders still face if the company is successful at paying off the convertible debt that could trigger a cash flow crisis at the company. Lucent has so far bought back about $1.6 billion of that debt at a cost of about 600 million shares. Those purchases have diluted existing shareholders by about 18%.

But the company has another $2.1 billion in convertible debt still out there. With the increase in the value of Lucent shares, buying that debt will result in at least another 14% dilution. And add in the projected 6% to 10% dilution that will result when Lucent issues shares to settle its class-action lawsuit with shareholders, and the stock faces a stiff uphill climb.

Extra Risk Without Much Extra Potential Reward

What links these examples from the bond and stock market is the willingness of investors to take extra risk without much in the way of extra potential reward. That's a logical result of the Fed's attempts to accelerate economic growth by increasing the money supply. The extra cash put into play by the Federal Reserve has to go somewhere, and with the extra supply of cash cutting the returns on Treasury notes and on the less risky parts of the equity market, investors are stretching for that extra penny of potential reward.

It's all too easy to justify that stretch since the market seems willing to accept the Fed's guarantee that interest rates will stay low, growth will pick up and Lucent will be able to dodge all the potential events and language in its debt agreements that could send the company back to the brink of disaster.

Frankly, I think that's putting too much faith in any central bank. Even Alan Greenspan can't guarantee that his policies won't be sideswiped by some runaway and random event. What if the dollar plunges? I don't mean a mere continuation of its current drop, but a real rout that shows signs of turning into a vote of no confidence in U.S. fiscal and monetary policy. Would Greenspan be forced to raise rates to head off that kind of crisis?

Or, more likely, what if the Fed can't deliver the growth for the second half that the markets are pricing into bonds and stocks? I think a second-half recovery is still the most likely scenario, but I can't ignore the possibility that the economy won't behave as expected.

The financial markets are full of uncertainty now, as they always are. And there is no way to avoid all risk. Even something as safe as Treasuries carries risks. In fact, it's that risk that generates the higher returns that corporate bonds and corporate equities have paid over time.

But that tradeoff between risk and reward only works as long as investors insist on being adequately compensated for the risks they take. Right now, there are significant corners of both the stock and bond markets where that simply isn't the case.

As usual, buyer beware. Even if you believe this rally is real and will finally put an end to the bear market of the last three years, this is no time to forget the very real risks that can lurk in individual stocks and bonds.

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