Opening Bell: Fed Says Markets Too Optimistic

August rate hike unlikely; more evidence that KBR ripped us off in Iraq; rethinking privatization; etc.

The Wall Street Journal and the Financial Times both go page one with apparent leaks from the Federal Reserve that the markets’ expectations of future rate increases are too aggressive and that the central bank thinks the financial system is still wobbly.

The FT says “senior Fed officials” think they won’t hike rates nearly as quickly as markets think they will, largely because they think they’ve got inflation relatively under control. The Journal writes that futures markets are pricing in a 90 percent probability that the Fed will raise rates in August.

An August rate hike can’t be ruled out. Between now and then, a raft of economic data, including two employment reports and several gauges of inflation, will be released. If the overall economy and the financial system show signs of rapid improvement or the inflation news worsens significantly, the Fed may decide to start reversing some of the rate cuts that began last September.

It appears the Fed is reacting to the run-up in interest rates over the last several weeks, something that could exacerbate the housing bust by making adjustable-rate mortgage reset payments higher and could slow the economy further at an exceedingly fragile time. Basically, either the markets are being too optimistic about their expectations for the economy, the Fed is being too optimistic about its expectations for inflation, or both. The “both” answer is the one to really fear, as it would signal stagflation has arrived in earnest.

The Journal implies that the market misinterpreted a speech by chairman Ben Bernanke last week that seemed to be hawkish on inflation, and now the Fed is walking that back a bit. It quotes an analyst saying monetary easing doesn’t usually stop until the unemployment rates peaks. Not many think that’s happened yet.

Meanwhile, The New York Times apparently missed out on the leak, but writes on A15 that Bernanke suggested yesterday that the Senate should convene an independent panel to help it navigate the health-care system in its bid to rein in ever-rising costs.

More evidence that KBR ripped us off in Iraq

The NYT says on page one that an Army official who oversaw the Pentagon’s multi-billion dollar contract with KBR says he was fired in 2004 for not approving shady charges by the Houston company.

The ex-official, Charles M. Smith, said KBR couldn’t explain or document more than $1 billion it was charging the government and he denied payment and was “suddenly replaced.” KBR, of course, was called Kellogg, Brown and Root until last year and was a unit of Halliburton, where Dick Cheney worked before he waddled into the White House.

This couple of paragraphs shows pretty succinctly how the military contractors can have the government over a barrel, even without the aid of their impeccable political connections.

Army officials denied that Mr. Smith had been removed because of the dispute, but confirmed that they had reversed his decision, arguing that blocking the payments to KBR would have eroded basic services to troops. They said that KBR had warned that if it was not paid, it would reduce payments to subcontractors, which in turn would cut back on services.

“You have to understand the circumstances at the time,” said Jeffrey P. Parsons, executive director of the Army Contracting Command. “We could not let operational support suffer because of some other things.”

KBR has raked in $20 billion from its Pentagon contract, the Times says, and just got part of a decade-long, $150 billion deal.

Europe has us “covered”

In housing news, the Journal on A3 says the Bush administration is looking to Europe for financing methods to “jump-start” the housing market. In focus are something called “covered bonds,” which are a $2.75 trillion market in Europe.

The paper says the bonds are mortgage-backed securities (cue horror music), but differ dramatically from the stuff that fueled the bubble. Unlike those, covered bonds aren’t sold off of a bank’s balance sheet and they’re backed by high-quality mortgages and the bank itself, should those mortgages falter. The Journal says they’ve been used for centuries in Europe.

The WSJ on A3 says the so-called Hope Now coalition of mortgage companies will speed up their program to help borrowers stay afloat. Somehow we’re skeptical.

White flight…back to the cities?

Meanwhile, home prices in Southern California fell 27 percent in May from a year ago, the Los Angeles Times reports. Putting that in dollar terms helps understand how bad this is: the median home price hit $370,000, down from $505,000 last May.

The LAT notes that in way-out suburbs, the price cratering was even more pronounced. In Palmdale and Victorville, prices are down an astonishing 42 percent and 43 percent respectively. Why there? People can’t afford to drive such crazy commutes anymore, even for cheaper housing. Thirty-seven percent of existing home sales were foreclosures.

The paper quotes an economist saying he thinks prices will have to fall up to 50 percent on average in the region to become affordable again.

The Journal posts a more in-depth too-expensive-to-commute story on A18, positing that the trend could “potentially reshape a half-century-long pattern of how and where Americans live: The driveable suburb—that bedrock of post-World War II society—is for many a mile too far.”

Pruning the hedge (funds)

The Journal takes a page-one look at turmoil in the maturing hedge-fund industry, where it says it’s not so easy to make it anymore.

It says new launches last year were down about half from three years ago and the industry is undergoing a kind of consolidation that’s familiar to any industry leaving its adolescence: the rich get richer, something the paper says “is helping the big funds play a more powerful role in shaping the business and financial landscape.”

It looks at the dashed—or at least seriously modified—hopes of one hedge-fund entrepreneur, who the Journal says was so absorbed in launching his fund last year that his $160,000 Maserati got impounded because he forgot to pay his parking bill. It was three months before he even noticed. The former JPMorgan trader fired half his workers after Deutsche Bank backed out as an investor and is now going into boring infrastructure investments.

Reforming the ‘shadow banking world’

The FT says Goldman Sachs is near a deal that would restructure a collapsed $7 billion structured-investment vehicle—a move the paper says could be a sign of more to come.

…the move will bolster hopes that banks are starting to create solutions to the long-running woes of SIVs, and the plethora of other, shadowy credit entities that have exploded in size this decade, in the so-called “shadow banking world”.

SIVs are off-balance-sheet vehicles that banks used to unload assets like mortgage-backed securities, only to have to take many of them back on their balance sheets. Not that we understand what’s really happening here from the FT’s convoluted story. Does this help?

The Cheyne restructuring, which has been brokered after nearly 10 months of negotiations, will require the receivers to organise an auction of the Cheyne assets in the coming weeks, to establish a transparent price for these instruments. This is important because in recent months it has often proved impossible to value these murky assets.

Once this price is established, Goldman will then create a new off-balance sheet vehicle to buy the assets, with the transfer of assets being funded by the US bank for just one day before being sold on to the new vehicle. Under the plan senior creditors in the SIV will be given a range of options including reinvesting in this new vehicle.

Didn’t think so.

To the water coolers!

The Journal reports on A6 that some communities are rising up against their private water utilities and threatening to give their governments control over them. One town in California saw a company buy its water in 2002 and propose a 74 percent rate increase.

Similar conflicts have flared up around the U.S. over the past few years—part of a backlash against a wave of water-works-privatization deals in the U.S. that began in the 1990s as cash-strapped municipalities sought to defray the costs of upgrading old water plants and other infrastructure.

It raises questions about all the other infrastructure privatization going on around the country, including that of toll roads.

McClatchy joins the sad parade

The Journal on B1 and the Times on C10 report that McClatchy is slashing 10 percent of its workforce—or 1,400 jobs—in a bid to save $70 million a year. The newspaper chain is hemorrhaging money. It’s ad sales were down 17 percent last month from a year ago. The Miami Herald will lose 17 percent of its workers. It’s not clear how many of the company’s job cuts will be in its newsrooms.

Milberg buys its way out of court

The Times goes A1 with news of a settlement by rogue shareholder-lawsuit firm Milberg LLP that will allow it to escape prosecution by paying the government $75 million. The Journal on B2 says it must also admit wrongdoing.

Milberg gave clients kickbacks to become lead plaintiffs in its class-action lawsuits.

For Lehman, the future is now

Lehman Brothers recorded a $2.8 billion first-quarter loss as expected. The Journal’s Heard on the Street column reports that the troubled Wall Street firm and its peers face years of troubles—a proposal to change accounting rules would force it to take assets it has sold off in recent months back onto its balance sheet.

It isn’t clear how much Lehman would need to take back onto its books under the proposed rule changes. But even the return of just 20% of its securitized assets could offset the firm’s recent balance-sheet reduction…

Investors are rightly concerned about the assets on Lehman’s books and whether the firm has sufficiently marked them down. They also may have to worry about assets they can’t yet see.

Has America ever needed a media watchdog more than now? Help us by joining CJR today.

Ryan Chittum is a former Wall Street Journal reporter, and deputy editor of The Audit, CJR's business section. If you see notable business journalism, give him a heads-up at Follow him on Twitter at @ryanchittum.