I previously have highlighted the importance of monitoring the banking sector as a leading indicator of where the Federal Reserve will take interest rates.  Bubbles in the housing markets have often led to painful banking crises in many different countries around the world and the fear is that the current bubble will cause the same effect as well.  This past Monday, banking regulators have already reported that the number of problematic loans held by U.S. banks is on the rise.  Compared to a year ago, loans that have a high risk of being defaulted on increased from 5.1 percent to 4.8 percent a year ago.  The biggest concentration of these loans is in the automobile industry, hedge funds, brokerages and insurance companies.  As defaults on loans worsen, we will see the impact on the profitability of regional banks, but loans to corporations are not the only problem.

Loans to individuals are also at risk of being defaulted on. The most common new mortgage held by millions of households in the United States is the payment option ARM (Adjustable Rate Mortgage) that allows borrowers to pick from a menu of selections. They can choose to fully amortize the loan, pay interest only or opt for the most dangerous choice of all by paying only a portion of the interest payments due each month - known as a negative amortization loan.  In plain English this means that the size of the borrowerâ�,��"�s mortgage actually increases over time because the unpaid interest payments continue to compound and accrue as liabilities. However, faced with escalating housing prices and stagnant wages, many US consumers have opted for the negative amortization option as a means of buying a home. Until now, most neg- amortization purchasers have enjoyed the benefit of rising house prices which allowed then to extract mortgage equity from their homes and in effect â�,��"grow out of their debtsâ�,� yet, with housing market cooling rapidly as days of double digit year on year gains clearly over, this strategy is no longer a viable solution. 

As ARMs reset to market rates, the doubling of monthly mortgage payments would of course send many of these already stretched-to-the-limit consumers into foreclosure, rapidly increasing the number of non performing loans for the banks. As for real estate investors, August new and existing home sales have been weak while the average sale price is falling.  Imagine a scenario where real estate investors see the value of their investments erode while their monthly adjustable rate mortgage payments keep on climbing higher â�,�“ if this trend gains speed, they may be desperate to dump their investments and cut losses.  Earnings from regional banks will not be released until October, but we have already seen many reports of downgrades of individual banks by analysts covering the sector. 

Amaranth -- A Painful Reminder of LTCM

Another serious concern that the Federal Reserve is watching is the extreme speculative nature of the financial industry.  News of the Amaranth loss brings painful reminders of LTCM.  In order to bail LTCM out, Greenspan surprised the market with an interest rate cut and followed the reduction with 2 more rate cuts.  Federal Reserve President Tim Geithner has already expressed the Fedâ�,��"�s concern about the large holdings of hedge funds in financial and commodity markets and how these positions are primarily financed by the banking system.  The fear is that if these positions move against the hedge fund, it can cause a big credit risk for the financial sector as a whole and hurt not only the hedge fund, but also the banks that lend to it.  The Federal Reserve is regularly in touch with the nationâ�,��"�s banks and given that this speech came shortly before the announcement of the Amaranth loss, we are sure that they are keenly aware of the problems brewing.  The sharp rise in oil was far too attractive for hedge funds to ignore.  We suspect that many more funds have leveraged bets on oil and are facing similar problems, albeit on a smaller and less newsworthy scale.  If defaults begin to become more widespread, the Federal Reserve may have to step in to stimulate the economy and increase liquidity, just like they did in 1998.

How to Beat the Street on Predicting for Rate Cut

We are at a tipping point in the US economy and if you want to get to get a leg up on the rest of the market in forecasting when the Federal Reserve will cut interest rates, you need to look beyond daily economic data and watch what the Fed watches.  Inflationary pressures are easing while the economy is in limbo.  Data has clearly been weakening, and everyone is watching consumer spending.   However one month of weak spending may not be enough to compel the Fed to cut rates, but if we begin to see cracks in the banking sector which will tell us how the housing market downturn is really impacting the bottom line of US consumers and corporations, the Federal Reserve may feel the need to act preemptively by cutting interest rates.  We are sure that Bernanke wants to avoid a recession at all costs.  If adjustable rate mortgages are straining the consumer, one of the primary solutions to ease the problem would be to lower rates to help reduce the monthly payments. 

Kathy Lien is the Chief Currency Strategist at FXCM.