Still in the loading zone but leaving soon

My next interest rate class will be held on Wednesday September 19th at 6pm in West Hollywood. This two hour class is an excellent addition to my newsletter. I will review my current interest rate forecast and give each attendee a 25 page book of charts that are given to my private clients. We will discuss current fed policy and I will share the one book that Chairman Bernanke uses as a daily reference tool. Space is limited and advance registration is required.

Do you hate waiting until Friday afternoon for your FREE copy of my interest rate newsletter? Would you like to have up to the minute information about interest rates, the economy and real estate? Did you know that I write a daily edition of the EWW packed with breaking news and insight that I have accumulated during the day? The cost for this daily e-mail is only $100 and you will receive every update through 12/31/07. Just complete this form and fax or mail to my office.

Last week’s headline was “it’s time to back up the truck” in which I was emphatically stating that the long end of the yield curve offered tremendous value as rates were going to continue their dramatic plunge to new lows. For those that haven’t completed the loading process, time is running short before we see the “key” 4.50% level on the 10-year fall and force the Fed to ease the Funds rate from its now lofty 5.25% level.

The Fed speaks softly

This morning’s speech by Fed Chairman Ben Bernanke was a let down for those who had hyped “the biggest speech of his term” and somehow thought it might be accompanied by a rate cut. I wrote last night to my daily subscribers that the chances of any significant remarks were very low. It’s amazing that our Fed head has promised us a “transparent” monetary policy but money market traders are thoroughly confused on the timing of the first rate cut of his administration. A few tidbits from the speech are important to review and give a little bit of insight into the Fed’s thinking but again I find them to be lagging behind the curve which means they will have a lot of catching up to do in the next few months. Big Ben told us: “In light of recent financial developments, economic data bearing on past months or quarter may be less useful than usual for our forecast of economic activity and inflation.” I have been writing for the past few weeks that the economic stats being released each week are meaningless and are causing many to focus on the economy from their rear view mirror. This has many of the so called “experts” sitting on the sidelines and missing the biggest bond rally in years. Until these forecasters jump in the rally will continue and of course that includes the players at the Fed house. Have you noticed that many of the daily mortgage broker letters continue to focus their lock predictions on day to day economic stats? Their world doesn’t operate like it did a couple of months ago and they will soon realize the mortgage market is now a function of spreads and not Treasury rates. Remember I wrote in March that Treasury rates would be lower after July 1st but mortgage rates would be higher so even if you were right about rates you suffered because of spreads widening.

Mr. Bernanke’s other important quote was: “housing may have indirect effects on economic activity, most notably by influencing consumer spending.” There is hope for the Fed as they are catching up to what I have been writing all year…..the housing and mortgage troubles are a sure bet to filter thru to the economy and the never say die consumer. If you take away funding sources (refis, helocs, etc) from the consumer he is left with only credit card debt and that will soon end in disaster for those trying to stay away from bankruptcy. It is clear that many homeowners are now using foreclosure the same way they did bankruptcy before the new regulations in 2005. Many are making credit card payments before mortgage payments as they realize that the value of their house has now fallen below the level of mortgage debt.

The Fed will lower the Funds rate by at least 25 basis points on or before the next FOMC meeting on Tuesday, September 18th. He did come closer today to the realization that the Fed must catch up to the interest rate markets with the remarks: “developments in financial markets can have broad economic effects felt by many outside the markets and the Federal Reserve must take those into account when determining policy.” Mr. Bernanke is well aware of how fragile market confidence can become and if he continues to use recent stock market strength as a barometer he may miss the underlying current of weakening consumer spending.

Bush offers a little bit of help

70 minutes after Mr. Bernanke’s talk in Wyoming, the President spoke to the country and proposed a small bail out for homeowners with mortgages of less than $362,000. His proposal is for the FHA (Federal Housing Admin) to guarantee monthly payments for those homeowners at least 90 days behind and facing foreclosure. These opportunities would only be available to people with good credit. These refi’s will center on homeowners who are “upside down” and see their mortgage balances higher than the value of their homes. The President has asked that the FHA limit on high priced housing states be lifted to the Freddie and Fannie maximum of $417,000. Earlier this week HUD (Dept. of Housing and Urban Develop.) ended any limits on the size of mortgages guaranteed by the Veterans Admin and now Ginnie Mae will be able to purchase almost any VA loan. The Washington Post had an excellent article this morning with a proposal for new modified 40-year mortgages where payments are adjusted to an amount the borrower can afford to make each month. If this really works it could take years to cut through the government red-tape and I’m sure there will be many proposals from legislators in the next few months as we aren’t that far way from next year’s election.

The good, bad and really ugly

This morning’s Contra Costa Times talks about a San Jose Credit Union that is offering conventional mortgage rates on loans up to $620,000 and no prepayment penalties. They have had almost no foreclosures in the last 10 years and the sales people are paid by salary not commission. They don’t offer option arms or any negative amortization loans.

The bad comes from the lenders that have already accumulated a large amount of foreclosed homes. An article from Wednesday’s edition of American Banker (subscription needed) tells us that these lenders seem to be traveling in the same boat as the Fed and chasing the real estate cycle down. One California real estate agent had the following quote: “Roughly two-thirds of lenders are still ‘chasing the market down’ by cutting prices in small increments over several months.” If they would wake up and begin pricing below the market they would be able to reduce their inventory and most importantly not be competition for builders who are stuck with new homes and sellers who can’t afford their monthly mortgage payment. Economics 101 teaches us that an increase in supply and a decrease in demand produces much lower prices and that is what we will see this winter in the major cities of this country. The mortgage mess has begun but the painful decline in home prices has not picked up the momentum that is sure to come over the next couple of years.

The ugly is news from the Mortgage Bankers Association that announced yesterday a stunning percent of mortgage defaults are in non-owner homes. Nevada leads the nation with 24 percent and then Arizona is second with 18 percent. California and Florida are not far behind and for those looking for a comparison to the early 1990’s the numbers were only 6%. These owners are sure to seek buyers at much reduced prices in an attempt to rid themselves of this albatross whereas the typical homeowner will try hard to stay in the house. I doubt very seriously the President’s new FHA plan will apply to those that don’t occupy the home.

Loan demand

Normally loan demand is an excellent indicator of economic activity for the Fed but today that may not be true. Today’s Fed h-8 report shows commercial and industrial, real estate and consumer loan demand increasing at a very rapid rate. Hopefully the Fed will realize that these loans are being completed as the available window shrinks for all but the best corporations. With commercial paper (corporate IOU’s) having dropped $244 billion in the last three weeks ($184 billion was asset backed) it’s not a matter of price but availability for these borrowers. As a result banks have seen credit lines drawn and loan requests doubled and tripled due to other markets being frozen (CP, securitized, etc.). Loan demand today is rising due to a severe liquidity crisis that will soon affect most other parts of the economy. If the Fed doesn’t see this soon, long rates will drop even further than I forecast and a severe recession will arrive in a matter of weeks.

Summary

One of the most important events next week will take place on Friday (5:30am) with the monthly jobs report. The actual unemployment rate is much more important than the number of jobs created due to massive seasonal adjustments. If the rate (currently 4.6%) rises it will give the Fed more ammunition (and cover) to lower the Funds rate. They know that a .5% increase in the rate (from the low) which would be a level of 5.0% is almost a sure bet to be accompanied by a recession. Wednesday’s 11am release of the Beige Book might show some of the early August weakness but the Fed needs to use a little of the “Greenspan gut feel” for this period because if they wait until they are sure there is a fire it will be too late to save the economy from a nasty set back.

Long-term rates are headed much lower (with or without the Fed) and this will be a very tough fall and winter for almost every sector (except exports) of the US economy. How far rates fall will be a function of how fast the Fed catches on and is able to provide liquidity and lower rates but this episode in economic history will clearly be marked by the following “Trends tend to stay in motion longer than anyone every expects and further than most can stay alive going the other way”. The trend towards lower rates and softer consumer demand is set in motion and not much will be able to stop this trend for the foreseeable future.

I will have an update for my daily subscribers on Monday evening around 10pm.

Have a safe and healthy Labor Day weekend!

It’s time to backup the truck

Do you hate waiting until Friday afternoon for your FREE copy of my interest rate newsletter? Would you like to have up to the minute information about interest rates, the economy and real estate? Did you know that I write a daily edition of the EWW packed with breaking news and insight that I have accumulated during the day? Just complete this form and fax or mail to my office.

Can you really afford to be without this information on a daily basis? Do you remember that I wrote early in the year that interest rates would begin their decline in July? On March 23rd I wrote that mortgage rates would rise but Treasury rates would fall thus increasing the spreads to lenders. My daily update subscribers receive everything before the weekly subscribers.

Gut instincts are an important part of everyone’s life. Everyone has the instincts but not everyone uses them to their benefit. Once or twice a year you step outside and see a clear blue sky or a few clouds with a little bit of a breeze and just know that a storm is on the way. You are at a baseball game for your favorite team and just know that with runners on first and third with one out that the batter is going to try a squeeze play. I often write that we only see life through our own experiences and we have seen article after article in the last few weeks from so called experts who tell us that “I have never seen anything like this before.” Early this year the Fed led us down a path of predicted economic strength and higher interest rates accompanied by no spillover from the housing sector. All of us would like to believe that the Fed has the most accurate crystal ball in the universe because then we can make lending, borrowing and investment decisions with near certainty. History shows that the Federal Reserve has frequently been wrong at major turning points with Fed speakers often telling us the Fed was going one way when just a few weeks later they were forced to change direction.

When the 10-year Treasury rose to 5.32% in mid-June almost every economist was forced to change their forecast to much higher rates for the remainder of 2007. The momentum from the move that began on March 13th at 4.50% forced everyone to change and then create excuses for why rates were rising. Second quarter GDP growth was the reason used for higher rates as a fear of higher inflation combined with growth at high levels of capacity utilization sent everyone (except us) into a tailspin and caused the ultimate disgrace for an economist…….whipsawed again as rates have plunged in the past 1.5 months. Now the hot debate is whether we will see a recession and is the Fed done with monetary ease?

Why was everyone so wrong?

When studying economic history I often will analyze the winners and losers in each economic cycle. It’s much easier to view after the dust settles and when you had no economic stake in the outcome. Early this year there was much talk of an end to the housing bubble and problems with mortgage loans. The consensus was that it would be a small problem in sub-prime and not spill into any other sector of the market or economy. The stock market continued higher in the first half of the year because the consensus was something that was comfortable and most importantly reasonable as no one had ever experienced anything else in their history. One of my key concepts of life is that the majority would rather lose in company than win alone. In other words it’s ok to lose my house if everyone else on my street or community loses their house but too scary if I’m the only one who had the foresight to make preparations for an economic setback. You probably think I’ve lost my mind and are sure that you wouldn’t mind winning alone but don’t be so certain until you have faced that situation numerous times. It was a very lonely road for the first six months of this year for anyone (me) willing to go completely against the crowd. Every day I received phone calls asking whether I was really positive that rates would decline in the 2nd half of the year. These people had business transactions, borrowings, investments, etc. that were time sensitive and everything they were hearing on CNBC or Bloomberg, reading in the Wall Street Journal or hearing from their friends went completely against everything I was forecasting. I could have easily changed my predictions and just gone with the crowd that was going to be wrong (again) but unlike most people whose thoughts come from what others say I stayed with my “gut” that has been developed over the past 40 years of witnessing economic events and my studies of the previous 100+ years of history.

Real estate is unusual because there is only one way to play the market and that is on the upside. There really isn’t an efficient way to “sell short” parcels of property so real estate agents, mortgage brokers, etc. have a vested interest in the upside as its rewards are far greater than the downside. The key word is “objective” because if you make your living on only one direction the chances of your ability to recognize the downside are lessened. For the past two years (see archives) I have written that this real estate cycle would be the worst anyone has ever witnessed and would last at least 5-7 years. The response I received from real estate agents was always: “I was around for the early 90’s and early 80’s so I’ve seen everything”. The response from real estate investors was “I’d welcome lower prices which would create excellent buying opportunities”. These responses were to be expected because we see life from our own experiences and the past has produced expected results without much risk. Unfortunately for the majority we are only at the very beginning of a long, painful bear market in real estate prices where many will learn the lesson that the RE industry doesn’t owe them a living just because it has occurred in the past. History does often repeat itself but not when we expect.

Long term rates will soon plunge to new lows

Plunge is a strong word that I rarely use with my interest rate forecasts. Once a year my “gut” screams out that it’s time to back up the truck because a major event is about to occur. Every economic cycle has four distinct parts and this year’s mortgage/real estate meltdown is a perfect example. The first part sees those with foresight and gut instincts making predictions and investments that will profit from a dramatic change in the direction of the underlying market. The second part is the actual recognition by the majority of participants that something has changed and that things aren’t the way they used to be. The third is where the early players liquidate their positions to those that now realize they must change or be run over by the new trend. The fourth part is where we see final liquidation of positions, jobs, investments, etc. by people who did not change and always believe that history will repeat itself and bail them out of an uncomfortable environment. Today we find ourselves between stage one and two as realization of a new trend has begun but for most it will take another 1-2 years before we complete stage 2. The most profitable opportunities always occur in stage 2 and we are now seeing the set up for a major move down in long-term interest rates.

The focus of the last few weeks has been entirely on the short term problem of liquidity in the financial system. With paydowns of almost $180 billion of commercial paper in the last two weeks the Fed has literally been begging banks to borrow a the discount window using mortgage backed paper as collateral. Short term treasury rates have plummeted as the ensuing flight to quality drove investors out of everything but government paper. Recently released economic stats tell us what happened weeks and months ago and that is irrelevant to what is occurring now which is why we have seen the interest rate on long treasury bonds (10 years and over) not decline anywhere near the drop in the short paper (5 years and under). The 10-year treasury could easily drop to the 3.80-4.00% level this year as the investors realize the US economy has hit a major speed bump and it will not recover for many months. The jobs report on Friday September 7th may be the first sign that something has changed as the unemployment rate should begin a rise that will surely create concern for the Fed. History has shown that a .5% increase in the rate (from any level) has led to a recession and a sure Fed easing. (40 out of 50 states reported a higher unemployment rate in July.)

The Fed

September 18th is the date of the next FOMC meeting but the Fed doesn’t need to wait until that date to lower the Fed Funds rate (currently 5.25%). Last week’s discount rate (50 basis point) reduction produced approx $2 billion of borrowings this week but I really can’t figure out why a bank would borrow at 5.75% when the Funds market is cheaper. The Fed is clearly trying to send a message to the money market that it wants to increase liquidity that was present only a few weeks ago. Mr. Bernanke has received high marks for his performance this year but I believe this may change in the near future. We want to believe that our Fed chairman is god-like but if you carefully review his speeches and FOMC statements from this year you will clearly see that the Fed has been behind the curve and fighting an inflation monster that has gone into hibernation. The Fed’s mandate is for a growing economy accompanied by price stability and big Ben needs to focus on the economy for the remainder of the year.

Countrywide

Countrywide’s attempt to stay afloat appears to have been thrown a life raft by Bank of America this week with a $2 billion investment through preferred stock. The interest rate is high at 7.25% and that might be expensive if my forecast of lower rates proves correct but the Comptroller of the Currency is reporting that the preferred stock investment can NOT be converted into common stock. The stock’s reaction to this week’s announcement was less than stellar and that might be a vote of no confidence from stock players that see the only way Countrywide can survive is as a much smaller lender. Their CD rates have risen this week as they try and raise more short-term capital but their mortgage rates are near the highs of most lenders and with their cost of money high their profit margins will be squeezed.

Commercial real estate

The current consensus is that commercial real estate is different and can’t suffer the pains we now see in the residential market. For those that tap the CMBS market for their financing needs fear has taken over as the lending spreads have widened past bank levels and many pending deals may not be consummated. An article in this morning’s Washington Post talks about a new reality for developers and builders in some of the biggest US markets. The lenders that are having trouble in the residential side are the same lenders in many instances in the commercial arena (Europe and Far East).

Summary

We will soon see that the problems in the mortgage arena have spread like a virus to many other parts of the US economy. 65% of all bank loans are from the real estate area up from 35% just 25 years ago. Consumers have been able to spend and spend the last few years due to the availability of cheap mortgage money and that has ended for at least the next few years. A depreciating dollar will help cushion the fall but with many of our major trading partners suffering from the mortgage problems their ability to purchase our goods and services may not be as great as it has been the last two years. A cheaper currency does reduce prices but if the foreign consumer is afraid to spend then it really doesn’t matter. Lower mortgage rates are coming soon but not many will be able to qualify due to much tighter borrowing requirements. We are headed for a Japanese style (low interest rates with little consumer spending) recession but it will not last nearly as long.

Saturday morning we have three Fed speakers (Fisher, Lockhart & Poole) at a regional economic conference in Biloxi, Mississippi. I will have an update on Sunday evening for my rapidly growing list of daily subscribers.

Long-term interest rates are going much lower

At 5:15am this morning the Fed went from a short-term mortgage lender to a long-term mortgage lender in an effort to keep up with the growing worldwide liquidity crisis. Last Friday I wrote about the Fed lending $ for the weekend to banks that were finding it difficult to obtain funds using mortgages as collateral. The repurchase agreement (repo) market is used for very short-term (days, not weeks) loans by the Fed and banks who have funds to lend or a need to borrow with the collateral usually government securities. This morning’s announcements that they were lowering the discount rate by 50 basis points and that inflation was no longer the #1 Fed concern did have a calming effect on many financial markets. The US stock market rallied and the yen fell sharply reversing trends of the past two weeks. In the general announcement the Fed took out any mention of inflation and added the fact that “downside risks to growth have increased appreciably.” The discount rate cut to 5.75% only effects banks that need to borrow on a more permanent basis and the Fed made it clear that they would allow loans “for as long as 30 days, renewable by the borrower.” The Fed clearly stated that home mortgages would serve as acceptable collateral. It has become obvious to the US central bank that the mortgage mess is not going away so they have made preparations for some of these mortgage securities to be housed at the Fed for many months.

On a side note, the announcement of a discount rate cut was approved by all members of the FOMC except St. Louis Fed President Poole who earlier this week told the world there was no reason for the Fed to move because the housing problem had not spread to the general US economy. Mr. Poole is now two for two as he told the world on April 10, 2001 that there was no reason for the Fed to lower rates and then saw the Fed drop the Fed Funds rate by 50 basis points a short five days later. Actually he could turn out to be a great contrary indicator for those who realize that some people always seem to be late to the party. The way we do everything is the way we do anything.

Fed Funds rate

The stated and set rate for overnight funds lent between member banks of the Federal Reserve remains at 5.25%. But with the daily rate having traded most of the week between 4.50-5.00% it should only be a few days or weeks until the Fed finally admits that the US economy is not nearly as strong as they forecast and that the housing problem is not confined to sub-prime loans. The next move could come at 5am or 1pm or even at the next FOMC meeting on Tuesday, September 18th, but it is clear that this rate is coming down and fast.

Long-term rates

The focus of the fixed income markets has been on the short end of the yield curve due to the flight to quality bid from those liquidating the “yen carry” trades and other leveraged trades. This focus will change in the next few weeks and offer investors an extraordinary opportunity to lock in current rates on long-term government bonds. Once the Fed confirms that inflation is not the problem and that a weakening economy is on the horizon we will see the 10-year Treasury rate plunge to the high 3%/low 4% level. Normally that would stimulate home prices and begin a new round of mortgage refinances. Unfortunately due to a lenders strike and new tighter underwriting guidelines this will mark an unusual time in history where we see the price of money decline (interest rate) but demand is unable to be satisfied due to lending restrictions.

Economic stats and inflation

This week saw the CPI increasing by it usual 2.4% annual rate but as I wrote the market is not reacting to old news and anything that happened over two weeks ago is old news. The interest rate market will soon begin to focus on the implications of a major cutback in loan demand (commercial paper dropped $91 billion last week) and a consumer that is now increasing expensive credit card debt in an attempt to hold off drowning from a lack of spendable funds.

The dollar, the yen and the aussie?

Worldwide markets continue to be led by the value of the yen and this week was no change in what has clearly been the theme for 2007.

Today’s US stock market rally was simply the tail end of a furious decline in the yen once the Fed announced its slight change in strategy. The most interesting event last night came from the land down under as the Reserve Bank of Australia (central bank) actually bought Aussie dollars as they were forced to intervene just two weeks after seeing record highs in their currency. There was fear that if the Fed lowered short-term rates the dollar would plunge but someone forgot that in times of global crisis the dollar is always the currency that can accommodate the assets of those seeking a safe haven.

Can anyone bail out the under water homeowner?

Many in Congress are speaking loudly (as usual after the fact) that government sponsored agencies (Fannie Mae & Freddie Mac) should have their lending limits (currently $417,000) raised so they can purchase jumbo loans. This might help some in states where prices are high (Calif, Fla. etc.) but wouldn’t effect the new strict underwriting guidelines that will be in place for at least the next few years. The answer………have the government allow banks to keep those underwater homeowners in the house and pay (market) rent to the banks until the market stabilizes. I know that banks aren’t set up for this but it is amazing how fast a business adapts when it is given an incentive by the government (see ethanol). It can work and will work and would expedite the end of this bear market that will go on for at least another 3-5 years.

China to the rescue?

China stopped buying mortgage backed securities earlier this year but I believe it is time for our growing trading partner to step up to the table and lend a helping hand. I propose having the Chinese Central Bank use some of its $800 billion of currency reserves to purchase mortgage backed securities from U.S. banks and the government could guarantee the Chinese against currency risk but not principal risk from the securities. It’s a crazy idea but it never hurts to try something new when it is obvious that a reduction in interest rates will not be able to stimulate credit demand.

The bear growls

I have written all year that this decline in real estate prices and destruction of the mortgage market was not a short-term problem. The real estate market has rewarded those who have bought every dip, leveraged to the max and made a phenomenal living from the never ending ride that somehow never goes down. This is a real bear market and bear markets last years not months and make the majority of participants run for the exits with the familiar refrain: “I’ve been around 20, 25, 30+ years and never have seen anything this bad”. We only see life from our own experiences and for 99.99% of Americans they are about to witness something they have never seen in their lifetimes. Hang on tight, this is going to be the roller coaster ride that only few will survive. If you react the way you have in the past you will be crushed by the bear, it’s time to think out of the box and not be afraid to win alone because the vast majority will be losing in company.

I will have a special update this weekend for my daily e-mail subscribers. To subscribe please click here.

The biggest mortgage lender in the world……The Federal Reserve

Today

A day that will go down as a historic day in US economic history. The Fed stepped in at 6am and announced that they would lend money to any bank as long as the collateral used for the loans were mortgages. After three separate interventions that totaled $38 billion, worldwide stock, bond and currency markets stabilized giving the Fed the weekend to create a more long-term solution. The Fed can and does provide liquidity at times of economic stress but it does NOT provide capital that is used on a permanent basis. This morning’s loans were made for the typical three day period and must be renewed or rolled over on Monday morning. Today’s action was not unprecedented and one which I have seen many times before: June 1970 the Fed stepped in with liquidity due to the bankruptcy of Penn Central railroad, June 1984 the imminent collapse of the Continental Illinois Bank (80% take over by the government), October 1987 stock market crash, October 1998 LTCM hedge fund collapse and of course the 9/11/01 tragedy. I have witnessed each of these events and many more not included in the list and each time the Fed arrived at the scene with unlimited liquidity. Two other major events came to mind today (I’m old but not that old to have been a witness) when observing today’s events. In 1886 the US suffered a mortgage bubble similar to today with interest only and no money down mortgages for buyers in Kansas, Nebraska and South and North Dakota. Of course there was no Federal Reserve or lender of last resort in those days so the result wasn’t very pleasant for both borrowers and lenders. The Fed (began 1913) was around to witness the Florida real estate bubble that came to an end with the devastating hurricane that hit South Florida in September 1926. It is often said that “those who cannot remember the past are condemned to repeat it” and the Fed has served as both rescuer (easy money) and villain (tight money) and actually made the correct decision today with its unlimited lending to mortgage holders who couldn’t find anywhere else to borrow.

Monday

The Fed probably will roll over the loans it made today and offer more financing to any bank that did NOT avail itself today of the Fed’s generosity. The Fed does NOT want to continue accumulating mortgages and is hoping that the overall lending market calms down to a point that normal lending policies for mortgages comes back. The Fed could roll over the “repos” to its discount window for longer term financing but the implications are never good for borrowers and would immediately send a signal to world wide debt markets that the problem is systemic and not temporary. It’s important to note that this is not just a US problem and that the European and Canadian Central Banks were quick to open their vaults to those institutions that needed liquidity in their regions. What is so different from the events listed above is that home mortgages continue to be funded every day and remember that for the vast majority of US the housing bubble is something that occurred in someone else’s neighborhood (Calif., Florida, Nevada, Arizona, etc.)

With the knowledge that the Fed has finally arrived at the burning building the stock market today slowed its recent decline and probably will spend next week climbing a wall covered with more bad news that has been temporarily discounted by most investors. With the massive amount of margin calls this week and the forced liquidations of hedge funds that were set up to make consistent profits many of the more solid stocks were smashed by those that learned “it’s not what you would like to sell but what you can sell.”

Japanese Yen

The yen continues to be the best barometer for world market health and today was no exception as the 117.8 level held before falling to 118.4 at the close. If the stock market is to hold next week we shouldn’t see any strength from the yen. The almost perfect relationship between the yen and the S&P 500 held this week and those that have bet on a break have been run over so many times that it is amazing they come back for more financial punishment.

Mortgage rates

Those seeking a home mortgage have been frustrated by the fall in Treasury rates but a widening of credit spreads due to lender fear pushing mortgage rates to highs for the year. The good news is that I expect mortgage spreads to narrow next week as the market begins to breathe BUT Treasury rates should rise as the recent “flight to quality” takes a respite and rates try to go back to a more normal mode where future inflationary expectations determine levels.

The Fed

It’s been long forgotten but just three days ago the FOMC announced that the Fed Funds rate would remain at 5.25% with an admission that “the housing correction is ongoing.” Unfortunately the Fed was blind-sided by the trigger for today’s Fed action…Thursday’s news that the huge French bank BNP Paribas couldn’t determine an accurate value for some of the securities in its money market funds. Amazingly the bank’s CEO was quoted last week as saying the bank’s exposure to subprime woes was “absolutely negligible.” The good news is that the ECB (Europe’s central bank) was able to loan $130 billion to BNP which alleviated its immediate cash crunch. The bad news is that a trend is clear….the world’s central banks have no idea what is going on in the financial markets they oversee.

Last week I wrote that the Fed should ease but asked if it wasn’t too little and too late. Yes, the Fed should and almost certainly will lower the Funds rate at least 25 basis points before the next meeting on Tuesday, September 18th (they will have a phone conference). The Fed is fearful of the messages that will be sent to the market if they ease. Any lowering of the Funds rate will be a tacit admission that the mortgage problem is a true crises and not a temporary problem and an admission that they clearly didn’t anticipate these events. The bigger problem is that a lowering of short-term rates will not increase credit availability or create more loan demand as is normally the case with lower interest rates.

China

One of the answers to our financial problems may come from China. I will be spending a great deal of time at next Wednesday’s class reviewing my forecast for the next 12 months and China may have to step up in a big way. The People’s Bank of China suspended purchases of US mortgage backed securities in May of this year. Over $700 billion of MBS are owned by overseas entities but without a penny from the Chinese and that may have to change for China to see a continuation of their recent strong economic growth. Earlier this week the London Telegraph printed an article that sent shock waves thru the currency market. A Chinese cabinet minister said that Chinese foreign reserves should be used as a “bargaining chip” in trade talks with the US. He also stated that “China doesn’t want any undesirable phenomenon in the global financial order.” This really isn’t much different rhetoric than we see from our US congressmen but the world markets know that the Chinese have more power to influence international relations than our politicians.

The future begins now

This week’s global meltdown was a result of a massive increase in leverage and the liquidity created by the yen carry trade. Years ago the Federal Reserve was able to control lending through its banks but now with hedge funds able to create funds through the yen and other currency swaps and then invest anywhere and anytime the Fed finds itself in a position where its actions don’t have the same impact as they did 20-30 years ago. This morning’s intervention was effective but mostly psychological and they will have to dig deep into their bag of tricks if we see more liquidity problems later this month. The Fed does have more power in the regulatory area and I anticipate a major change in underwriting guidelines for mortgage loans especially concerning the stated income variety that are the source of many of our current problems. This website appears to enable borrowers to pay a fee for a verification of employment or housing based upon a simple request and nothing more. It is hard to believe these sites will survive the coming government reforms.

The US economy

Next week will bring retail sales on Monday, PPI (wholesale inflation) on Tuesday, CPI (retail inflation) on Wednesday, Housing starts and permits on Thursday and finally consumer sentiment on Friday. These stats tell us what happened last month and I’m not sure the market really cares about the past. It is obvious that loan demand has crashed and within a month or two we will be presented with stats on C&I loans and real estate loans that show a major decline which is something that the Fed follows closely in determining monetary policy. The mortgage market will spend the next 5 months on life support. Fannie Mae and Freddie Mac will continue to lend on conforming loans (417,000 & under) but with underwriting standards elevated so borrowers will be hesitant to borrow unless absolutely necessary. Home buyers are frozen and waiting for the obvious break in prices that is coming to a your local neighborhood. Sellers are hoping and praying for a miracle that has no chance of arriving for years.

We are in a vicious and long bear market for real estate prices and now will surely enter a period of economic contraction as the US consumer pulls back from the spend, spend, spend era we have witnessed the last few years. Long term interest rates will head much lower as inflation becomes a worry from the past and the Fed’s focus centers on how to stimulate the economy. It’s been a long time since we have seen this kind of pull back and the rescuer in the end will not be the Fed but the Central Bank of China but that is a story for another day.

I hope many of you are able to attend next Wednesday’s (8/15) class where I will go into much greater detail about the opportunities and risks investors face over the next 12-24 months.

The Fed must lower short term interest rates but it may be too late…..

Another week where stocks fell, interest rates fell, the dollar fell (versus the yen) and the only asset that increased in value was a US Treasury bond. Liquidity is the most prized asset to investors and treasuries are the best place to hide in times of confusion and turmoil. I spend a great deal of time each week reading (newspapers, blogs), watching (CNBC, Bloomberg) and listening to other opinions to get a feel for what is occurring in the marketplace. Knowing where others place their bets and why can be very helpful in determining the course of future events and especially when calculating an accurate risk/reward ratio. I found it fascinating this week to hear the consensus opinion that the economy was healthy (with the exception of housing) and the problems in the mortgage arena would be a blip on the screen to most economic observers (unless you are a real estate agent, mortgage broker, etc.). This week’s problems are clearly a siren call to the Fed that they must hear and respond in a way that is calming to most market participants.

A Summer No One Will Ever Forget

History has shown that a Fed easing solves most economic problems so that borrowers have access to the financial markets. What makes the summer of 2007 so different is what makes this so dangerous for those who predict the future based upon their own experiences in the past. Most of the forecasters predicting that the Fed will solve all of our problems with lower short-term rates have memories that only go back to the 1998 LTCM crises and the 1987 stock market crash. Those events were transitory and needed an infusion of liquidity from the Fed to stimulate borrowing at lower interest rates. The current mortgage problem can NOT be solved with lower short-term interest rates. As I wrote on March 23rd: “Soon we will see the prime mortgages priced at higher spreads to treasuries and it would NOT surprise me to see Treasury rates much lower in six months but mortgage rates higher due to a cut back in demand from securitized buyers at current spreads.” This week we saw Treasury rates plummet (4.68% on the 10-year) but mortgage rates soared as lenders try desperately to stay in business by making loans that have a reasonable chance of staying current. The Fed is truly in a box that they did not create but clearly is not big enough to hold the answers to this unique problem. If the Fed lowers the Funds rate (next FOMC meeting on August 7th) it will be admitting that it is reacting to the problem instead of using its forecasting models to predict the future like it has told us for the past 2 years.

Where Is The Fed?

The Fed’s #1 asset is the confidence it holds for its constituency (the world financial markets) and when it shows that it clearly missed the boat (and it has sailed away) on the mortgage problem the repercussions will be long lasting for worldwide markets. Most likely they will soon lower the Fed Funds rate by 25 basis points with a statement that they are ready to do what is necessary to make sure liquidity is enough to keep the US economy growing at a healthy rate with low inflation. BUT and it’s a big but…….lower rates will NOT bring back residential borrowers because of tightening underwriting standards and a fear from lenders who purchase these loans. Securitization has been the fuel that has powered the incredible growth in mortgage lending. The ability to fund and then sell a loan (for a fee) has enabled lenders/banks to give a home loan to everyone in America regardless of their income, assets or salary. The ultimate buyers of these loans (foreign governments, hedge funds, pension plans, etc.) had an insatiable appetite as long as property values increased every year thus making it easy to meet even the most onerous monthly mortgage payments by refinancing their loans and taking out even more cash for spending. It kept the US economy going strong and made lenders even hungrier (lower rates and spreads) to find borrowers who would like to borrow to purchase a home.

The Scoreboard

This game has now come to a crashing end as the lenders have learned that these assets (loans) that they purchased on leverage have fallen in value to such an extent that many lenders have been wiped out. How could this happen so fast? Let’s look at a big German lender, IKB, that only 10 days ago announced that it was off to “a successful start to its financial year”, but needed an $11 billion bailout this week from the German state bank, KfW. It appears that IKB had valued these loans at “par” even though they had fallen in price on the false expectation that if they were held to maturity they would surely receive their entire principal. That’s fine if these loans are fully paid for but when they are leveraged maturity is irrelevant if you can’t hold on till the end.

FNMA & Freddie Mac

Lenders have completely pulled out of the market because of the nastiest word in the financial community: “confusion”. I have often written that markets will rise on certainty (even if it is bad news) but will plummet on uncertainty (even if it is good news). Global asset markets are plummeting because of massive uncertainty regarding the actual values of US mortgage loans and this uncertainty will be with us until each lender finds a way (not easy in an illiquid market) to accurately value its loans (assets).

I do anticipate a call from Congress asking Fannie Mae and Freddie Mac to step up and purchase conforming ($417,000) loans under both full doc and stated income criteria. Unfortunately this will not be of much help to many in California, Florida, Nevada and Arizona but the majority of states have average home sales that fit into the conforming limits. This will put a floor under the mortgage and housing markets and solidify the base for a move forward in 2008.

Too Late?

So the Fed must lower short-term rates but it really can’t help the mortgage market because so many borrowers can’t qualify at any interest rate due to a cut back in stated income, neg-am, pay option arms, etc. (jumbo) loans that will soon be extinct. It will be at least 5 months before the mortgage market clears the uncertainty and we will see at least 33% of the people in this industry looking for a new occupation by the end of the year.

The Good News

The Fed will ease, loan demand will NOT increase and the dollar will continue to fall in value. The good news is that our trading partners can probably prevent us from slipping into a deep recession due to demand for our goods and services at sharply lower prices (lower dollar). This appears to be the only solution for the Fed as US consumer demand is sure to contract sharply over the next few months. With the mortgage market not able to create spending money for the never say die consumer credit card debt (at high interest rates) will soon be the only outlet for necessary (gasoline, food) and unnecessary purchases. A lower dollar will bring in foreign buyers who see our stock market as a bargain. A lower dollar will not bring inflation due to a cut back in loan demand and a drop in the velocity of the money supply. An easing of monetary policy will bring a strong relief rally but when reality sinks that this will NOT stimulate loan demand.

Does The Economy Matter?

Today’s jobs number showed an increase of 92,000 for July and an increase in the unemployment rate to 4.6%. This week the Conference Board announced that households viewing jobs as “hard to get” declined to 18.4% from 20.5% in June. The “jobs are plentiful” category rose to 30.5% from 27.6% last month. The market is not focusing on any economic stats as that is the past and it’s the future that has investors worried and for a good reason. Consumer spending is the key to growth in the US and the best place to monitor these purchases is through sales taxes. Nevada reported this week that sales of taxable items fell by 3.6% in May led by furniture sales which fell 60%. The states that saw the greatest impact from the housing boom will be those that suffer the most from a cutback in spending.

The Yen

The yen continues to be the driver for almost all world markets. It has taken years for the build up in short positions of yen and the unwind will not take place in a few weeks. The chart of the S&P 500 versus the yen shows a very strong correlation that should be monitored daily. Eventually it will break but it doesn’t pay to guess and those that try will be run over like those that predicted that the mortgage problem was temporary and not having any effect on the economy.

It’s A Big, Bad Bear market

The most common comment I hear from realtors, mortgage brokers, etc. is: “I’ve been around for 25 years and seen everything, this is a short-term pause and it’s always a good time to buy a house.” It’s a good time to buy a house if you can withstand a 3-5% decline in value every year for the next 5 years and are not leveraged to a point where you can’t make your monthly mortgage payment. Real estate is a very unique asset with huge tax advantages and no way to sell short (bet on lower prices). As a result everyone looks for good buying points and not places to sell and stay away thus making it hard to be objective about purchase decisions. Bear markets are not short but slow, painful periods in history where those that try and pick a bottom find that quicksand occupies much of the landscape. Just because you made your fortune buying real estate or make a living as a realtor or mortgage broker does NOT mean that history will repeat itself, it does mean that you see life from your own experiences and you expect the past to repeat in the future.

The real estate world has been hit by a category 5 hurricane. Yes, it will survive and live to fight another day but not in the same form. Interest rates are headed lower as loan demand slows dramatically and the US economy enters a domestic recession. The Fed has a chance to limit the damage and the world has a chance to help us recover thru purchases of US items. It’s not too late but the clock is ticking……

Next week

I will have at least two updates next week for paid subscribers to my interim newsletter. Tuesday’s FOMC meeting will surely cause a lot of market movement and then I will have more comments on Wednesday or Thursday.