I think it is way too early to claim that the worst is over for the mortgage backed securities market. Yesterday's disclosure from Thornburg Mortgage (TMA) that it was forced to pay $300M in new margin calls, in my opinion is simply the first warning bell of what's might be another spiral of write downs and thus more dilution to come in the financial sector...

TMA situation to me is significant for several reasons. During the "go-go" days of the subprime boom, Thornburg represented a "gold" standard of conservative underwriting standards in the whole sector. They also only kept the highest quality assets on the balance sheet and thus even when the whole subprime sector caught a fever last summer, TMA was widely believed to be a "thriving oasis" in the subprime desert...

But when the commercial paper market effectively shut down back in August, TMA share price tumbled from high 20s into teens in a matter of days. Being a contrarian investor myself, I sensed fear and thus opportunity, and after carefully studying their balance sheet, I started a position. But to my surprise TMAs share price kept declining daily. So assuming that their portfolio was of high enough quality to sustain some short term losses I bought more... Long story short, it was one expensive lesson and I won't repeat it again...

TMA not only turned out to be one of my two largest losers during the whole contest but also taught me a valuable lesson- in the event of the severe dislocation in financial markets, asset quality is significantly less important than steady and ample access to liquidity. Because of their heavy reliance on the short term financing in a form of commercial paper, TMA was forced to sell some of their best assets at a huge discount to meet margin calls, which triggered more write downs and thus more margin calls...

But after huge write downs and liquidity injections last fall, things seemed to have gotten much better for the troubled lender. They actually managed to report a profit in the most recent quarter and have even paid a dividend again. Stock has rallied strongly just like the rest of the financial sector...Unfortunately, as the most recent announcement from TMA and UBS confirms, it looks like we might be in for another round of the same troubles...

I know there have been a number of reports in the media stating that conditions have improved markedly for the battered financial sector, but I personally question this logic for a number of reasons. First, it is true that rate cuts from Bernanke Fed theoretically increase the value of assets on the balance sheet and thus help the financial sector. These rates cuts also usually lead to lower mortgage rates, but not today and the main reason is -inflation. Mortgage rates actually hit a multi month high this week according to Bankrate.com

If Fed can't read the writing on the wall- I think someone needs to spell it out- "No more rate cuts!!!" I personally think that Fed is either asleep at the wheel or they are just playing some of kind of silly game that I personally just do not understand. We keep hearing a story from most Fed officials that inflation is not really an issue and that headline inflation number excluding food and energy does not matter... And we are talking about 4%+ inflation? This kind of hands-off attitude towards price stability is simply incomprehensible and irresponsible for a head of central bank of a developed country.

The truth of the matter is simple- inflation is always driven by excess liquidity and thus is "always and everywhere a pure monetary phenomenon". So while blaming high inflation onto high oil and food prices is a very convenient cover up for the populist politicians, the truth is much simpler- both housing bubble and oil bubble are a direct result of lax monetary policy- period...All the explanation about the Chinese demand impact etc -are simply overblown- the world has plenty of spare oil production out there and even most recent OPEC's moves where to CUT production- case closed...

Now, going back to the current situation- the excess liquidity generated by silly rate cuts has to end up somewhere, and given the widespread risk aversion, instead of going towards the productive areas of the economy, it is now simply being washed up into the assets that either have no risk- like treasuries, or into the assets that are perceived to be bullet proof to the US recession- like Emerging markets and commodities.

But as a skeptical capitalist I just simply don't buy into the emerging market "decoupling story" or into the "peak oil" theory. To me these are simply the next two big areas of "bubble" trouble and the most recent rate cuts are simply throwing more gasoline on fire. My prediction is that if RTP/BHP merger actually did close (highly unlikely), several years from now it would have the same ending as the AOL/Time Warner merger did...

As far as financial sector recovery goes- my rationale here is again very simple- we have not yet really seen any small regional banks go bankrupt; we have not yet seen commercial real estate related write offs from the large banks; we have not yet seen the LBO related debt write offs and in combination with tightening underwriting standards these write off will likely lead to more equity dilution. Thus buying into the sector is still very premature... What's more, with many players rallying strongly since Fed's January cuts, I think there is a real opportunity out there to actually short some of them...

Anyway, enough rambling for now
My summary advice is still the same- be careful, hedge your downside whenever possible and avoid the "this time is different mentality"...

Please feel free to e-mail me at skepticalcapitalist@gmail.com