More Drama Still For Subprime?

Is a rate cut enough to create a bottom for equity markets? While I think the subprime's actual financial impact is muted, its the reverse in sentiment it caused which has been doing more havoc rather than real financial consequences. Hence when assessing a bottom for equities in general, we need to look at recovery in sentiment.

Things Casting A Dark Cloud Over Sentiment & Market Psychology

a) The rate cut is insufficient to cause a substantive recovery in sentiment

b) The subprime drama still has a long way to play itself out. There will still be more hedge funds and financial institutions revealing losses every other day. News and media will continually focus on houses being foreclosed in US every now and then. Holders of CDOs and its related instruments will complain that there is NO market to dispose these instruments, and hence difficult to market them to market.

c) The big concern is not subprime but that "credit" in itself has stopped functioning: so much so that genuine demand for credit gets halted.

d) Goldman Sachs predicted that there could be at least a 15%-20% decline in housing prices in the US before they see things bottoming out. HSBC is even more dire forecasting an overvaluation of 35%-40% in US housing.

Things That Could Reverse Sentiment Positively

a) Big influential investor stepping in to bid or buyout of one of the bigger troubled mortgage companies - e.g. Fannie Mae or Warren Buffett or some big hedge fund like Blackstone or KKR.

b) The Fed aggressively tackles the liquidity and sentiment issues by cutting rates by another 50 basis points again to 4.0% before September is over.

Markets will drift lower as the things in the upper category will be pervasive in the news and media. Spurts of recovery will find it hard to reverse the sentiment or psychology.

However, I think the two possibilities in the lower category are real probables. Especially the first one. I do believe there are many shrewd investors, including Buffett and the big hedge funds, already pouring over the stocks whacked by subprime. Bank of America shrewdly pumped in US$2 billion into Countrywide in exchange for a 7.25% convertible preferred stock. The deal allows BoA to convert into Countrywide shares at a steal of US$18 considering the market price of US$23, which could translate to a 16% stake.

I do see still a lot of liquidity in the system, and the smarter hedge funds with some real balls will stick their necks out to bid for these distressed assets. The best thing would be for Buffett to step in and bid for one of those companies - now that would really kick it up a gear. Topping the list of potential candidates to be rescued or bought out include Thornburg Mortgage and Accredited Home Lenders. The change in sentiment driven by these deals will be sufficient to turn sentiment and market psychology around. I do see something happening within the next 1-2 weeks or earlier even, hence a good strategy will be to buy on weakness.