The health of banking sector still remains a big concern as a fresh bankruptcy by a home builder deals yet another blow to local banks. Speculation has always a problem for the Federal Reserve and right now they are juggling two speculative bubbles, one in the housing market and the other in the hedge fund sector.  Both of the bubbles are beginning to let air out, but the Fed is keeping a close eye on them to ensure that the deflation of bubble goes smoothly.  Unfortunately, we are already beginning to see complications that could force the Fed to cut interest rates prematurely.  US economic data has been very mixed over the past two weeks, which makes it even more important to look beyond the economic calendar and watch the other sectors that the Fed watches - like banking.

Home Builders Beginning to File for Bankruptcies, Straining Lenders, Worrying the Fed

On October 11th, Kara Homes, a major New Jersey homebuilder with assets of $350 million filed for bankruptcy.  They are one of the first decent sized builders to make such an announcement, but it is unlikely that they are the only ones feeling financial strain at the moment.  Larger homebuilders such as Lennar, D.R. Horton and KB Homes have already signaled that they will be reporting weaker profits or lower sales.  The impact is being felt across the board as Karaâ�,��"�s bankruptcy deals a major blow to its creditors, who are regional banks such as Amboy National.  According to the Ashbury Park Press, Amboy holds $58.2 million in loans with Kara Homes Inc.  Unfortunately for Amboy, this is the second time in five months that they have had to deal with faulty loans.  Real Estate Mogul Solomon Dwek of Ocean Township bounced a $25.2 million check five months ago and had his assets frozen by a Superior Court judge. Amboy says Dwek owes it $49.7 million, which makes it the largest bank creditor in that case.  Ashbury Press also adds that Amboy was not the only bank included in the Kara bankruptcy filing. National City Bank of Philadelphia holds $48.2 million on loans to Kara. North Fork Bank of Edison holds $21.3 million; TD Bank North of Portland, Ore., holds $15.9 million; Yardville National Bank holds $7.8 million; Magyar Bank of North Brunswick holds $7.5 million; and Park Avenue Bank of New York holds $3 million in loans to Kara.  Karaâ�,��"�s bankruptcy may be a good time for investors to think about whether more banks are exposed to this same problem.  In the past year, bank exposure to mortgages and home loans has hit an eight year peak.  If more of these bankruptcies occur, the Federal Reserve may have a much more serious problem to deal with than inflation.

Regulating Hedge Funds Has Become So Concerning That it is on the G8 Agenda

In terms of the hedge fund sector, the market has joined Fed officials in their call for more regulation.  Over the past week, every single major financial paper has extensively covered the debates in the industry about how to enact more regulation.  After the demise of Amaranth Advisors, no one wants to see another debacle lead to a liquidity and banking crisis. The problem lies largely in that the $1.5 trillion hedge fund industry is virtually unregulated. Though attempts have been made to bring these funds under the jurisdiction of the Securities and Exchange Commission (SEC), a court in Washington, DC struck down rules requiring their managers to register with the regulatory body. The current lack of oversight has troubled observers wary of the potential effects of future hedge funds unwinding massive losing positions. Amaranth has resurfaced painful memories of Long Term Capital Management (LTCM), a hedge fund whose implosion in 1998 prompted then-Fed chairman Greenspan to slash interest rates to cushion the financial fallout of the firmâ�,��"�s $4.6 billion dollar loss. Today, the prospect of a sizeable shock could be even more serious. As recently noted in the NY Times, hedge funds now account for roughly half of all trading on London and New York stock exchanges. With the number of hedge funds invested in volatile energy and commodity markets growing at a staggering 40% per year, the domino effect of a correction could be quite profound. An added concern is the fact that institutional investors such as pension and university endowment funds are increasingly allocating more of their capital to hedge funds. Finally, robust lending to hedge funds on the part of many high-profile banks and on a smaller scale regional banks, creates the possibility of a full-blown financial meltdown should a large liquidation bring a slew of Wall Street big wigs down as well. As noted by a senior SEC official, â�,��"the real concern is the transmission mechanism of the failure of a hedge fund. You donâ�,��"�t want [it] to bring down a Morgan Stanley or a JPMorgan.â�,�  The concern is so widespread that it is no on the G8 Agenda.

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.  Economic data has been very confusing these days with headline inflation prices falling and core prices rising.  Every single piece of positive data has been met with if, and or buts.  Nothing we have seen thus far has been compelling enough to tempt the Fed to make any changes to interest rates.  However, as we begin to see more 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. 

Kathy Lien is the Chief Currency Strategist at FXCM.