Last week's 25-basis-point rate cut was too small, according to most on Wall Street. But a vocal minority believes it was unnecessary and that the Federal Reserve's aggressive policies are contributing to the very deflationary pressures the central bank is trying to forestall.

By keeping the fed funds rates so low, and indicating it won't be raised anytime soon, the Fed has dramatically lowered the cost of capital for corporate America, as evinced by the recent torrent of convertible bond issuance.

History isn't repeating itself, but it is rhyming. When the Fed lowered interest rates in the late 1990s, the resulting liquidity fueled the IPO boom, bringing public a number of companies with questionable prospects. Within the Fed's current policy, convertibles are playing a similar role: allowing many companies that might otherwise have gone bankrupt -- or forced to look for a suitor -- to stay afloat, preventing consolidation in many sectors and curtailing pricing power for all competitors.

But Richard Bernstein, chief U.S. strategist at Merrill Lynch, worries "investors will soon be calling Mr. Greenspan 'Greenspan-san' for his Japanese-like strategy of keeping overcapacity alive," as reported here.

"What's basically happening is Washington in general, not just the Fed, is trying to solve a supply problem" -- really an oversupply problem -- "with demand solutions," Bernstein said in a subsequent interview Friday. "The Japanese have tried for many years to fill up their oversupply with created demand. They haven't been able to do it and I'm not so sure we'll be" either.

Bernstein is clearly in the minority among Wall Street strategists -- most of whom view the Fed's policies as reason to be more bullish -- but some share his concerns.

"Unfortunately, there are periods of pain that have to occur in capitalism. They cleanse the system," said Fred Hickey, editor of The High-Tech Strategist. "When that's not allowed to happen, you end up with a messed-up system. The unintended consequence of all this money being thrown at the economy is this overcapacity problem." The most obvious example being the tech sector, where capacity utilization was 62.5% in May vs. a 20-year low of 74.3% overall.

Feeding the Tech Zombies

The Fed is "keeping the walking dead alive," contends Mark FitzGerald, semiconductor analyst at Banc of America Securities, noting there've been no big bankruptcies or mergers in the chip space despite the industry's worst-ever recession. "The marginal suppliers, both chip and equipment, need to exit the business or be consolidated before a healthy recovery in profits can begin."

Granted, for as long as weak players are kept afloat, investors don't have to worry about losing the value of their stocks via bankruptcy. But neither can they realistically hope for decent profit growth, since the resulting overcapacity keeps companies from regaining any pricing power.

"Certainly this current availability of easy money through many of these convertible bond deals has made it less likely that you're going to see some consolidations, primarily because some of these companies now have more cash on hand," agreed Jim Liang, a semiconductor analyst for Pacific Growth Equities. "In that respect it delays the ultimate resolution of overcapacity."

Recent offerings of securities that start as bonds but may later be converted (hence the name) into equity include a $200 million deal last week from RF Micro Devices ( RFMD).

Preaching to the Converted

The boom time for converts isn't limited to the tech sector, as the accompanying chart reflects. A record number of convertible deals, 53, were priced in June, according to Morgan Stanley's The $16.9 billion in proceeds -- following $14.7 billion in May -- was the highest month since $20.8 billion in May 2001.

Cash Converts
A sampler of recent convertible bond deals
Issuer Ticker Business Total Amount filed (millions)
Cell Therapeutics CTIC Biotech $75
Continental CAL Airline 175
Cypress Semiconductor Corp CY Semiconductors 500
EDS EDS IT Consulting 600
Lattice Semiconductor LSCC Semiconductors 200
LSI Logic Corp LSI Semiconductors 350
RealNetworks RNWK Internet 100
Reliant Resources RRI Energy 225
RF Micro Devices RFMD Semiconductors 200
WebMD HLTH Health 300
WesternWireless WWCA Wireless 175
Xerox XRX Imaging 920
Source: Banc of America, and TSC.

The flood of cash from convertible bond offerings only compounds the balance sheet distortions that are a legacy of the late 1990s. Skeptics such as Bernstein believe the "balance sheet repair" story is largely a myth.

"The data show companies have just suspended capital spending in the hope the cycle turns," he said. "They haven't gone through significant balance sheet repair." (Overall capital spending fell at an annualized rate of 4.8% in the first quarter and is down 14% from late 2000, The Wall Street Journal reported.)

This is not to imply that every company that issues a convert is seeking a reprieve from the executioner. But clearly there is overcapacity in areas such as airlines, wireless and merchant energy, and these deals won't alleviate those conditions. Quite the contrary.

As General Motors ( GM) priced its colossal $17.6 billion offering last Thursday, which included a $4 billion convert, contributor James Cramer wrote: "GM gets to live to lose money again."

Maybe this really is good for GM shareholders and pensioners, as Cramer declared. But where's the virtue in GM being able to extend its "triple zero" financing offer? Other automakers have been forced to mimic those incentives, cutting into the profitability of the entire sector even as demand is starting to wane.

"There's gross overcapacity in autos worldwide," said Hickey. "Somebody is going to go away, but not if they can float nearly as much debt as their market value, as in GM's case."

Cramer is a trader -- a "weatherman," by his own admission. His point was that there's currently more than ample demand -- thanks to aggressive monetary and fiscal stimulus -- for the supply of paper being issued by corporations. If supply were to overwhelm demand, Cramer will no doubt change his upbeat outlook. (Notably, he wrote a more critical piece Friday about the "unintended consequences" of this liquidity-driven environment.)

But others can only see the dangers in the Fed's policies, regardless of the boost financial markets have recently enjoyed.

"Mr. Greenspan keeps talking about deflation, but he created it and he's the one that keeps it going," said Hickey. "At some point you're pushing more debt on people with too much debt and it's not going to work. You might get a lift for a month or two but I'd say the market has already built in all this good news."

Merrill's Bernstein similarly worried about the "whopping expectations built in" to current equity valuations. "We're in a speculative environment and the Fed has added fuel to the fire," he said, calling their policies "counterproductive."

The Chairman's Advocate

To be sure, not everyone sees peril in the Fed's policies.

Ayaz ul Haque, director of DFJ ePlanet Ventures, a $650 million investment arm of Redwood City,Calif-based Draper Fisher Jurvetson, noted that private companies running low on cash are "finding it relatively easier to arrange bridge financing, which tides them over until subsequent rounds of funding," or a public offering, if/when that market revives. "Lower interest rates are assisting them in doing that on relatively better terms," Haque said.

John Lonski, senior economist at Moody's, agreed there is a "negative feedback" of monetary stimulus -- specifically, "extending a lifeline to ailing companies in industries suffering from excess capacity."

But "I don't think this unwanted feedback provides reasons for the Fed to stop cutting rates," he said. "On balance, they're still having the effect of stimulating expenditures."

Rather than the Fed, the policies of the Justice Department and Federal Trade Commission might be bigger impediments to industry consolidation, the economist suggested. Those regulators have judged merits of proposed mergers largely on the impact on consumer prices, which is not their mandate, Lonski suggested. " Their decisions have run counter to Fed efforts to minimize price deflation."

Furthermore, the improved equity market resulting from monetary and fiscal stimulus "ought to eventually aid the process of mergers and acquisitions," he continued. Higher stock prices will "give the strong more incentive and currency to take over the weak, and pursue consolidation in a manner more orderly for the economy and society than outright bankruptcy."

Maybe the love/hate triangle involving J.D. Edwards ( JDEC), PeopleSoft ( PSFT), and Oracle ( ORCL) will prove a harbinger. But anecdotal evidence suggests otherwise.

After announcing their respective quarterly results, Morgan Stanley dampened hopes for a rebound in M&A activity and Goldman Sachs cautioned there was only minor improvements in its investment banking backlog.

Finally, Silicon Valley legend Sanford Robertson, currently a partner at Francisco Partners, said his leveraged buyout firm "can't buy public companies" because corporate directors want 50% premiums over current stock prices.

No doubt one reason directors are holding out is because the Fed has helped keep hope alive, even in places where it arguably shouldn't be. That may be a "good" thing for short-term traders, but it also threatens to undermine the longer-term recovery and prolong the post-bubble hangover.

Aaron L. Task writes daily for In keeping with TSC's editorial policy, he doesn't own or short individual stocks, although he owns stock in He also doesn't invest in hedge funds or other private investment partnerships. He invites you to send your feedback to Aaron L. Task.

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