The Hindu Business Line : Market View

The US economy has shown moderations in the first half of this year. Housing activity continued to worsen and employment slackened. Though retail sales showed a pick up last month, the general trend was one of a slowdown.

The after effects of the sub-prime mess threatened to derail the economic activity further. Credit conditions remain tight and mortgage lending activity has slowed down. The Housing industry is crucial to the US economy and the Fed sees a major risk to the economy on its deteriorating state.

One key reason for the rate cut would be to manage the amount of interest rate resets on mortgage loans happening in early 2008. Almost $520 billion of loans are due for repricing in the first half of 2008. A lower benchmark interest rate and a stable house price scenario then, would definitely aid in managing the re-pricing, without too much risk of higher delinquencies and foreclosures.

Foreclosures are bound to be higher at a time when house prices are falling and the EMIs are increasing. This cut in interest rates would lead to lenders lowering their PLR’s and thus softening the relative impact of an interest rate reset. The lower lending rate could also spur new purchases of houses stabilizing the house prices.

Given this bleak scenario, the FED probably had no alternative but to cut interest rates and soften the impact. A 25 or 50 bps holds no relevance, I guess. It might need to do more if the problem worsens.

The Indian market: No surprises from the way Indian asset prices would move post the rate cut.

The cut is seen to be alleviating the credit problem and also increase liquidity leading to higher flows in to emerging markets and thus to India.

But we believe that the long term impact of the sub-prime problem would be a reduction in leverage levels. Northern Rock, the UK mortgage lender, in a liquidity mess now, has an equity base of £3 billion and an asset base of £113 billion. Leverage of 37 times!! Most of the US and European investment banks also have leverage of around 20 times. Hedge Funds have known to leverage around 15-20 times on their capital. The industry would move to tighter lending standards over time and central banks would tighten prudential norms. This would impact the overall levels of leverage and liquidity. Remember Leverage = Liquidity!!

QUANTUM MUTUAL FUND

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