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The Fed's Next Victim

Almost as surely as war takes casualties, Fed rate hikes in recent decades have triggered disasters of one kind or another in global financial markets.

But many analysts believe that the Federal Reserve's string of victims, from Franklin National Bank in the 1970s to Orange County in the 1990s and the flattened tech bubble of the year 2000, might not grow much longer in the current tightening campaign.

Other observers worry that the next victim could be a pretty big one: the U.S. consumer.

After taking its key overnight lending rate, the fed funds rate, to 1 percent, the lowest level in more than 40 years, the U.S. central bank this summer has started ratcheting rates back up.

It's widely expected to throw another quarter-point hike on the stack next Tuesday and could add several more hikes in the next year, in an effort to take the overnight rate to a mythical "neutral" level, from its current red-alert emergency level.

What is neutral? "When we arrive at neutral, we will know it," Fed Chairman Alan Greenspan said last month, in typically Delphic fashion.

David Rosenberg, chief North American economist at Merrill Lynch, suggested one possible landmark to let us know when neutrality has been achieved:

"Maybe we only know when 'you are there' when we get the first financial calamity, which has been part and parcel of every tightening cycle over the past three decades," Rosenberg wrote in a recent note, helpfully providing a list of the victims, including Penn Square Bank in 1982; Continental Illinois in 1984; Askin Capital Management in 1994 and Long Term Capital Management in 1998.

There's almost no telling which individual firms will get stung this time around, though there are a few anecdotal hints, such as the recent news that Aether Systems (AETH: Research, Estimates), which invested heavily in tech just before the bubble burst, has recently taken the plunge into mortgage-backed securities, just as mortgage rates have begun to rise.

Merrill senior economist Jose Rasco suggested that some Japanese and Chinese banks -- not exactly models of health to begin with -- could be vulnerable.

Closer to home, Rasco also suggested the firms involved in the U.S. housing market, which has been driven into the stratosphere by super-low rates, could also be vulnerable.

"In the United States, we have this leverage situation, with home equity borrowing and consumers' use of that leverage and the risks that presupposes," Rasco said. "That whole sector of the financial services business, those particular types of lenders ... are sort of exposed here."

Even the recent mild rise in interest rates led No. 2 mortgage lender Washington Mutual (WM: Research, Estimates) to warn of falling revenue, leading some investors to look askance at others in the sector, including Wells Fargo (WF: Research, Estimates), Countrywide Financial (CFC: Research, Estimates) and Golden West Financial (GDW: Research, Estimates).

Steady Fed could ease the pain

Still, many analysts believed that WaMu's problems were unique to WaMu and that the other firms would weather the storm of higher rates.

What's more, many observers believe the Fed has been so excruciatingly careful to telegraph its rate hikes this time around that most financial firms with any sense have battened down the hatches for higher rates, meaning the Fed's trail of dead could be shorter than usual.

“The Fed's painfully aware of this, and that's one of the better reasons they try to telegraph what they're doing, so people don't get caught," said Lakshman Achuthan, managing director of the Economic Cycle Research Institute, an independent research firm. "The institutions that have taken decisions that might put them into harm's way are probably fewer."

The Fed is expected to raise rates very, very slowly, possibly not hitting the elusive "neutral" level until 2006. Meanwhile, the "real" fed funds rate, which excludes the rate of inflation, might remain low enough for all but the most thick-headed institutions to survive.

"I wouldn't be especially concerned about a major episode of financial distress resulting from the recent and forthcoming Fed rate hikes," said John Lonski, senior economist and bond analyst at Moody's Investors Service. "I don't think it would be enough to cause pain -- unless you have people managing financial institutions being very reckless in their oversight of the situation."

Consumers at risk?

But U.S. consumers, some of whom refinanced into adjustable-rate mortgages when rates were at rock-bottom and then burned up all their home equity, might not have the ability to hedge against higher rates.

Lonski doubted this segment of the population would be large enough to do real damage to the overall economy, but other economists aren't so sure.

"I have to believe that, more than ever before, some importantly large number of Americans are exposed to short-term interest rates through the mortgage market," said James Grant, editor of Grant's Interest Rate Observer, "and an important, dramatic rise in those rates would choke off consumption."

As long as rates rise gently and the labor market improves steadily, most economists agree, most consumers should survive. Fiddle with either of those variables, and you could have trouble.

"If for some reason the Fed has to act more aggressively, or if for some reason the job market does not cooperate, then you probably have more of an imminent danger in the consumer debt area or the housing area in particular," said Achuthan of ECRI.

But James Grant, a vocal critic of Greenspan, suggested that, despite the pain, rates should rise, and relatively dramatically, to stifle the potentially dangerous speculation that super-low rates have encouraged.

"As much anxiety as we might extend over the victims of a rising funds rate, we ought to also spare a thought for the consequences of rates having been here in the first place," Grant said.