The Fed attempts to shut the door, but is it too late?

The Office of the Comptroller of the Currency (bank regulator) finally announced this morning that it was requiring lenders to be more careful about managing risks when issuing home loans. We have been waiting for these new rules for many months but wonder if it is too late to really make a difference in a real estate market that has clearly peaked and entered a vicious long bear market. The emphasis is clearly on giving the home-buyer/owner more information about the risks of negative amortization, option arms and other non-traditional mortgage products. Until the regulators begin on-site visits to implement these rules these products will continue to receive most of the attention by lenders due to a much higher commission rate for their sales people and a desperate desire to stay in their house by homeowners. Unfortunately these regulations should have been issued a couple of years ago before the bubble burst but the government rarely anticipates, preferring to react when it is clearly too late to make an impact. http://www.federalreserve.gov/BoardDocs/Press/bcreg/2006/20060929/default.htm

Long term rate decline pauses……

This past week saw the US 10-year actually rise 4 basis points to close at 4.63%. The yellow flag remains raised due to the fact that the bond/interest rate market needs a few weeks to catch its breath before moving to new lows for this cycle. With a Fed Funds rate of 5.25% the Fed will NOT move to lower this rate until the 10 year drops below 4.50% for a period of weeks and that is not likely until the end of the year. The constant daily pounding of housing prices dropping has been fully discounted in the market and offers no support for bonds until next year when it becomes painfully obvious that this is NOT like previous cycles and that we have entered a period of housing prices that no one has ever experienced. The first dip always appears an excellent buying opportunity to those with cash to invest but the reality that the dip is nothing more than a cliff that has no support and will send late buyers heading for insolvency as they realize there is no buyer for their ill-timed purchase. The consensus is that this is nothing more than a pause just like the early 1990’s and new buyers will be rewarded in a year or two…..sorry, not this time….it’s unfortunate but true that we only see life as we have experienced it……when you have experienced every dip turning quickly into a profitable opportunity you join the masses and buy, buy, and buy more…the only good news is that people would rather lose in company than win alone and soon recent buyers will have plenty of company in a market where there are no shorts to help break the slow consistent fall in home prices that we will see over the next few years.

Next week’s calendar

Wednesday finds Fed Chairman Bernanke speaking to the Economic Club of Washington at 9am on the topic of savings (the US has a negative savings rate) and he may take questions after his speech. If he wants to send a message (a Greenspan favorite hobby) this would be his opportunity. Friday the jobs number is released at 5:30am but it is doubtful that the market will react unless completely out of range (over 200M or under 75M) as interest rates have been more focused on 2007 inflation and economic prospects rather than current conditions. Clearly the bond market is telling the world that the US will have a major slowdown in activity in 2007 (led by the housing sector) and that current inflation rates (2.5%) are at the high end of the range and will soon decline to a more manageable 2% or less. The markets are also discounting a Fed ease in early 2007 and that might be overly optimistic as the Fed clearly wants an inverted yield curve for the foreseeable future as they will NOT give the housing market a chance to rebound due to much lower short term rates.

Bottom Line

Long term interest rates are headed much lower BUT not in the next few weeks.

Long term interest rates headed for 0.00%?

Last Friday the US 10-year Treasury rate was 4.79% and one week later is now 20 basis points lower at 4.59%. A 20 point move in one week is a rare and extraordinary move for the bond market. If this rate of decline were to continue we would be at 0.00% in early March 2007 but this has less than a 0.00001% chance according to this writer. Obviously last week’s yellow flag was too early but as I have written for months, long term rates are going much lower but more likely towards the end of this year.

The week in review

Wednesday’s main event was the FOMC meeting that produced an expected “no change” in the Fed Funds rate (5.25%). The Fed’s statement http://www.federalreserve.gov/boarddocs/press/monetary/2006/20060920/default.htm was also a non-event as they continue to publicly show a tough front against future inflation pressures while knowing that the chances of any further interest rate increase are close to nil. Thursday’s catalyst for the bond market advance came from a normally non-moving economic indicator, the Philly Fed survey which is only a regional view of business conditions. http://www.phil.frb.org/files/bos/bos0906.html Today rates again plunged but without any news events, so what really happened this week?

Loan demand falling off a cliff?

Many times the markets tell us about the economy before the actual statistics are released to the world watching on CNBC and Bloomberg. This afternoon the Federal Reserve’s weekly banking statistics http://www.federalreserve.gov/releases/h8/current/h8.pdf showed what may be the end of one trend and the beginning of another in loan demand. The price of money (interest) is set by demand from those that wish to borrow (corporations, house buyers, etc.) and supply from lenders (banks). Real estate loans have been a major part of bank’s loan portfolios for the past few years and that number has increased almost every week for the past 8 years. This month we are seeing for the first time an end to this uptrend and what may be the beginning of an actual decline in real estate loans. It’s too early to be sure but part of this week’s interest rate decline came from those that keep a close eye on loan demand and see banks with too much money chasing a declining amount of product. We also saw a very significant amount of money moved from the commodity market into the safe area of Treasuries by hedge funds that were liquidating losing positions after the recent decline in almost all commodities (gold, oil, lumber, etc.) and a fear that the HUGE ($5 billion+) loss by a major hedge fund in the gas market will spread to other funds that were thought to be safe but are taking on more risk than previously believed by their investors.

Yellow flag remains

A yellow flag is a sign of caution not the end of the move to lower rates. When we finally reach our long awaited destination of the 10-year at a 3%+ level it will be time for the red flag and a sign that everyone should lock their long term mortgages at record low rates. The 10-year can easily hit 4.50% level in the next couple of weeks BUT (and it’s a BIG but) any move lower will put tremendous pressure on the Fed to lower the Funds rate to 5.00%. A negatively sloped yield curve of 75 basis points (Funds versus 10 year) increases to “very likely” the probability of a recession and the Fed will NOT allow its “fear of inflation” to stand in the way of its primary objective of keeping the economy growing enough to create at least a few jobs each month. Sentiment surveys are now showing over 90% of traders long the bond market and that is usually NOT a good time to be betting on lower rates over the next few weeks. Again the interest rate market needs to rest, this is NOT the end of the move and we are headed for much lower rates but not in the next couple of weeks.

Shaq enters the real estate market at the top?

Shaq O’Neill is a great basketball player and a sure bet for the Hall of Fame but it is doubtful that his latest investment will set records for profitability. The Miami center watched the real estate market rise for years and now has decided to invest in a billion-dollar Miami mixed-use project that may mark the top for this cycle. http://www.miami.com/mld/miamiherald/sports/15559482.htm

Summary

The interest rate decline that this letter predicted the first half of 2006 has unfolded almost exactly as planned with a final destination of under 4% in the US 10-year treasury note. Over the last 40 years the average move down in long term rates in the 2nd half of the year has been 140 basis points (5.24%-3.84%) and ended 124 days later (June 28-October 24). This the average move over the past 40 years and does NOT mean that 2006 will see a repeat but it does give you an idea of where we might be headed in the next few months (not weeks). The most important point to remember is that the so called “experts” who continue to tell us that the Fed is not finished tightening (higher short rates), inflation is headed higher (we will see the peak in the next couple of months) and have missed this BIG move down in long term rates continue to be wrong. When they finally throw in the towel and admit they were wrong again (they have only a 30% win rate over the past 40 years) we will have exited with BIG profits and historic low rate long term mortgages. Keep your seat belt buckled as the next few weeks will be rocky but the view gets better as we come closer to the end of the year.

The caution flag is being raised

One of my favorite expressions is “when they are yelling, you should be selling” and the bond market acts very poorly considering this week’s positive economic news. This morning’s announcement that CPI (retail inflation) rose only 0.2% for both core and all items was met with buyers of 10 year Treasuries but by 10am the market was all sellers and closed the week at 4.79%. Thursday’s retail sales release showing a tepid 0.2% increase for both all items and ex-autos was also greeted with 10 yr. Treasury buyers but after a couple of hours the sellers came in and yields rose 3 basis points. The two biggest economic news releases of the week showed good news for those needing or hoping for lower long term rates but instead found the 10 year up 2 basis points for the week. When a market does NOT rally on good news then it is sure to fall quickly on bad news.

The caution flag is only being raised for the short term (weeks) and does NOT represent a change in my long term (months/years) outlook for much lower long term (10 year) rates. Loan demand is softening (especially real estate) and consumer spending is stalling even though the price of oil has fallen over 15% in the past couple of weeks. The problem with the interest rate market is simply that everyone is betting on the same outcome, an imminent Fed easing. The long positions by speculators in Treasury securities has reached all time highs and at least a few weeks of consolidation is needed before we can move to much lower rates later this year.

Commercial real estate underwriting guidelines to tighten?

With the bursting of the residential real estate bubble and the start of a long bear market, the commercial real estate market has quietly continued to grow to record levels. Thursday Fed Governor Susan Bies spoke about the Fed’s worry that banks have increased their concentration of commercial loans especially investor properties (not owner user properties). She and the Fed are concerned that underwriting standards have weakened at a time when cap rates (return on capital) are at historic lows. CRE assets have grown from 160% to 294% of bank capital in the last 10+ years and is one of the reasons so many banks are trying to increase their C&I (commercial & industrial) exposure and reduce their CRE loans. http://www.federalreserve.gov/boarddocs/testimony/2006/20060914/default.htm

How could so many be so wrong?

From England comes the news that 770,000 home buyers have defaulted on their home mortgage. The average first time home buyer in England borrows 90% of the purchase price (in the US 45% borrow 100%) and borrow a record 3.24 times their income. The housing bubble appears to be losing steam across the pond as 13% of 21-24 year old homeowners missed at least one mortgage payment in the past year. http://business.guardian.co.uk/print/0,,329575973-108725,00.html

Oil drops from $77 to $63 but the airlines lose more $$$?

Someone needs to teach a course in “How to run an airline” as these poor companies have lost billions as oil prices have risen to levels so high that airlines actually lose less money on the ground than in the sky. Now with oil prices falling the airlines have found another way to lose their shareholders hard earned capital. Most of these flying giants watched and watched as fuel prices rose never considering that maybe they should hedge themselves and purchase fuel for the future (Southwest is the exception). In the last couple of months American, Continental and United all threw in the towel and decided that they would purchase fuel for future delivery at record prices and of course they bought at the exact peak ($77) so they now are members of an exclusive club that loses money when oil rises and falls. http://chicagobusiness.com/cgi-bin/news.pl?id=22053&bt=fuel+hedges&arc=n&searchType=all

Fear versus Greed

A few months ago the Chicago Fed sponsored a conference on the housing market bringing together bankers, academics and other regulators to discuss the state of the industry and the risks ahead. The lenders were acutely aware of the risks in “soft” underwriting standards but it appears from reviewing the state of the market today and how it remains easy for almost any borrower to obtain financing using stated income, stated assets, stated identity, etc. that greed continues to win the mortgage lending battle. The market place never lets greed win for very long and the long punishing bear market in home prices will soon turn these players around and head in a direction very far away from today’s playing field. http://www.chicagofed.org/publications/fedletter/cfloctober2006_231a.pdf

Final Thoughts

Unless you have been on vacation for the entire summer on a distant island with no communication you are well aware that house prices have begun a descent to lower levels. What has not received much publicity the last few weeks is the sudden drop in commodity prices that include sugar, corn, cocoa, copper, gold, silver, etc. Although this might seem a non-event to many, it’s important to remember that many of these items will have a positive impact on inflation figures later this year and 2007. According to the Copper Development Association almost 50% of total copper usage is used in building construction with 65% of that in home construction. Lower commodity prices are a result of softening demand and a dramatic increase in supply that always follows higher prices.

Inflation is headed lower, long term interest rates will be lower but for the next few weeks the interest rate market needs a breather and soon the yellow caution flag will be replaced by the green flag. Its time to take a few chips off the table as this has been a great summer for those betting on lower interest rates.

Fear of rising inflation versus house price declines

The battle lines have been set and the war could last for months but in the end the “experts” will again be wrong with their predictions of higher inflation and more increases of the Fed Funds rate by the Federal Reserve. This week’s announcement that Unit Labor Costs (ULC) rose at an annual rate of 4.9% in the 2nd quarter sent the inflation “worriers” begging for the Fed to increase short rates to fight off the coming price rises that inevitable follow from higher wages. The problem with this logic is that history has shown that wage increases are the last part of an economic advance and is primarily the reason why unit labor costs are included in the index of “lagging” economic indicators NOT the “leading” index of economic indicators. On the other side of the debate is the fact that the housing market has begun its long awaited bear market and this will have a negative effect on jobs, consumer spending and consumer confidence. The US bond market is treading water with long term rates holding in the 4.75-4.80% range (10 yr.) as it attempts to decide who will be correct in this wide ranging debate about the future of the economy.

The Fed’s Beige Book

Wednesday the Fed published its current edition of the “Beige Book” which is a survey of current business conditions in its 12 districts which cover the entire country. http://www.federalreserve.gov/fomc/beigebook/2006/20060906/default.htm
Although it is a dry 30 pages of reading there are always a couple of nuggets that are buried in the report and each member of the FOMC uses this summary as one of their tools in deciding what they will suggest to the Fed Chairman in its next meeting on Wednesday September 20th. The Kansas City Fed saw an increase in housing foreclosures and the San Francisco Fed found little ability to pass through higher costs into the prices of manufactured goods with the exception of energy-intensive goods. The good news is that oil has nearly passed its seasonally strong period of August and September and considering that unlike last year when we saw prices much higher, this year the oil market fell a few dollars a barrel. When markets can’t rally into seasonal strength they almost always fall sharply into seasonal weakness and the two weakest months of the year for oil are November and December. A drop in gasoline prices will have a stimulating effect on consumer spending and will give hope to the residential market but because this is a bear market and not a crash a pause will only trap the buyers that can’t wait to buy on the first pull back in prices.

Home prices…going, going and soon gone much lower

Tuesday saw a very detailed report from the Office of Federal Housing Enterprise Oversight (OFHEO). http://www.ofheo.gov/media/pdf/2q06hpi.pdf
The report showed the obvious in that Arizona showed the most appreciation in the past year (24.05%) and Michigan showed the lowest appreciation (1.01%) in the last 12 months. No surprises from a report that analyzed price movements over a year to year period and not from the past 3 months where we see price weakness taking over most areas in the country. The number of house sales is falling but I’m quite sure this is not a good indication of the level of price weakness. House prices have no exchange to trade (stocks, bonds, commodities) so information is more difficult to obtain on a current basis. The best way to describe current conditions would be that sellers want last year’s prices (higher) and buyers want next year’s prices (lower) and this is causing a drop off in actual closed sales.
I am looking for something similar to what was witnessed in Japan in the early 1990’s and read a great article this week from someone who watched as prices soared out of range and then bought the first pull back only to find that the ledge was a cliff that soon broke to lower prices, it could easily happen in the US as there are too many buyers waiting to buy at slightly lower prices. http://www.bullnotbull.com/archive/japan-tale.html

Loan demand

According to Freddie Mac the median interest rate of refinancings is now at 1.05 meaning that homeowners are financing at an average rate that is 5% higher than their previous rate. (e.g. 6.30 vs. 6.00) This has only occurred two other times in the last 20 years (1989 and 2000) and is a sure sign of stress in the mortgage market. Why refinance at a higher rate than you had unless you it was a necessity…..

The Fed loan stats released this afternoon show a very unusual event as the outstanding amount of real estate loans at the end of August was LESS than at the end of July. Real estate loans represent 53.3% of total bank credit and if this is the beginning of a trend change the Fed may be forced to ease (lower Fed Funds rate) sooner than anyone expects. Commercial and Industrial loans continue to climb and now equal almost 20% of all loans with the consumer category down to an all time low of just 17%.

Bottom Line

After an almost straight line down to 4.73% the 10 year is resting at the 4.75-4.80% level. Next week has a 10 year auction on Tuesday, retail sales on Thursday and the CPI (consumer inflation) on Friday so the market will be moving on expectations of higher inflation. The FOMC meeting is coming on Wednesday September 20th and expectations are almost unanimous for no change in the current Funds rate of 5.25%. Market based long term rates should stay in this area for the next few weeks before we see another leg down to new lows in the 10 year. The key continues to be how fast the housing decline filters through to consumer confidence and spending versus the lower price of oil which will be an offset.

Mortgage loans at 0.00%???

When markets are liquid (prices quickly reflected by motivated sellers), like the stock, bond and commodity markets, prices are a true reflection of current demand conditions. Over the past couple of years domestic auto dealers (due to slowing demand) have used 0% financing as an incentive to pull buyers to the showroom floor. It is much easier to end a promotion than to lower auto prices and then raise them as this would confuse potential customers. Today Chrysler begins a program of 0% financing for six years which is generally longer than most consumers will actually own their car.

The housing market is a perfect example of an illiquid market where sellers are very reluctant to lower prices. BUT, there is a BIG problem for those seeking buyers for their house as the new competitor on the block is very motivated, the home builder that has a large inventory. With the housing market at the very beginning of a severe BEAR market, I look for many home builders (especially condos) to begin offering 0% fixed rate financing for the first 5 years on any new home purchase as they desperately seek buyers. This will make it more difficult for the individual home seller to compete at today’s prices and will start a “selling war” which will create lower prices over the next couple of years. I am NOT predicting a “crash” in home prices but rather a very slow (3-5% per year) bleeding that will not end for at least 5-7 years. Bear markets end from exhaustion where sellers exit from time not price levels. Although recent statistics show that house prices are flat to slightly higher this does NOT include the incentives that individual sellers are offering to prospects. In Santa Clarita one motivated seller is offering a free Toyota Prius instead of lowering the asking price: http://www.santacruzsentinel.com/archive/2006/August/31/local/stories/04local.htm . Unfortunately in many areas (San Diego) condo sellers will be forced to lower prices quickly, of the 6,927 properties on the market (6/06) over 80% are attached units: http://www.pasadenastarnews.com/business/ci_4263948

Many mortgage lenders will not be able to escape the coming carnage as Thursday H&R Block announced a quarterly loss of over $100 million due to increasing liabilities from its ownership of Option One Mortgage Corp. http://www.hrblock.com/presscenter/pressreleases/pressRelease.jsp?PRESS_RELEASE_ID=1457 Although the government is due to release long awaited new underwriting guidelines later this month it should have no effect on the market as motivated sellers will be driving prices lower for the foreseeable future.

Many are asking if this decline in house prices is similar to the bursting of the tech bubble of a few years ago. The tech boom of the 90’s created productivity gains that still remain today, the housing boom has done nothing more than transfer wealth from non-home owners to home-owners and caused a dramatic lowering in the US savings rate as home-owners saw no need to save when their home equity could be used as a piggy bank. America’s growth was built by workers spending less than they earned and not by rising asset prices caused by world central banks flooding the market place with money that was used for leveraged asset purchases.

Shorts sales and the return of distress property buyers

They’re back…..short sales where the home owner negotiates with the bank (lender) to give back the house and extinguish their debt at a reduced level. Northern California (Sacramento) has seen a dramatic increase in short sales as home-owners desperately try to avoid bankruptcy. http://www.sacbee.com/content/business/v-print/story/14308557p-15198889c.html This news is bringing out the “grave dancers” who have been anxiously waiting for the once in a lifetime opportunity to buy properties that will soon appreciate to new lofty levels. There are many multi-billion dollar pools being created for new investors to enter this market but I am afraid they will find this to be a cliff on the way down to lower prices instead of a permanent bottom. Many times last year I wrote about the first pull back in a bear market and that it ultimately creates more sellers as they realize that their timing was very early and requires an enormous amount of patience as this decline will take place over years not months.

The consumer is pulling back

Wednesday Costco announced that its gross margins are lower than planned due to heavy competition and reduction of demand from the consumer. Shoppers are buying less discretionary items and high gasoline prices are now effecting its high-end consumers. http://seattletimes.nwsource.com/html/businesstechnology/2003236872_costco31.html

The consumer drives spending, the growth of the economy and the demand for loans (interest rates). From St. Petersburg, Florida comes a quote from a hair stylist who has seen her clients cutting back on weekly appointments. http://www.sptimes.com/2006/08/30/Business/Economic_gloom_tighte.shtml

Today’s jobs report

At 5:30am it was announced that August saw 128,000 new jobs created with most of the gain coming from the service sector. Average hourly earnings rose by only 0.1% so those predicting a higher inflation rate will have to wait another month. With over 30% of all jobs created in the past five years coming from the real estate related sector it will be very difficult for job creation to stay above 50,000 over the next 12 months. Yes, U.S. corporations are sitting on record cash reserves but it’s important to note that this is caused by uncertainty of future economic conditions. The upcoming recession will not end until the consumer replenishes savings and corporations begin drawing down their reserves.

The Fed

Tuesday (8/29) the Fed released the minutes of the FOMC meeting held on August 8th. The details gave us a few clues to future monetary policy decisions to be made at the next meeting on September 20th. The Fed is clearly pleased that long term interest rates are declining: “Yields on nominal Treasury securities fell in line with policy expectations over the intermeeting period.” The Fed’s next move (lower the Fed Funds rate) will occur when it sees that economic conditions (home prices) continue to deteriorate and long term interest rates (10 yr) have dropped enough to give the Fed the cover it desires but in reality doesn’t really need. The other key quote: “The full effect of previous increases in interest rates on activity and prices probably had not yet been felt….and saw limited risk in deferring further policy tightening.” Actually the Fed (Mr. Bernanke) is well aware of conditions in the housing market and probably sees the chances of raising short term rates at less than 1%. Clearly the Fed’s next move is to ease (lower short rates) and the timing will be dictated by the level of the 10 yr. and the shape of the yield curve (now inverted by 50 basis points) http://www.federalreserve.gov/fomc/minutes/20060808.htm

Conclusion

Since January 2006 we have been writing that the first half of 2006 would see rising long term rates and the second half of the year would see a fall in these same interest rates. There is no reason to change that forecast as long term rates are now down 50 basis points since their peak on June 28th (we were two days off in our prediction of the peak at the end of the first half of 2006). Although the US bond market clearly needs a “pause to refresh”, the news is clearly one sided and will continue to show that the US consumer is “tapped out”, real estate loan demand has peaked and housing has a much bigger impact on the economy and consumption than the so called “experts” have told us this year. History does repeat itself (housing slows down) but the magnitude of this decline will be greater than anyone has ever seen…….Lower long term interest rates will NOT save the housing market but it will offer great investment opportunities for those holding US Treasury bonds.

IMPORTANT NOTE: My next interest class “Everything you want to know about interest rates but were afraid to ask” will be held in Downtown Los Angeles on Wednesday November 15th from 8:00-11:30am. The cost will be $250 and all proceeds will go to Food on Foot ( http://www.foodonfoot.org). Seating will be limited and registration will begin early next week. I will discuss my forecast for Fed policy and the direction of long term interest rates in 2007.