The Fed should place a call to David Blaine

At 11:43am on Wednesday (1/23) I sent the following special e-mail to my daily update subscribers: I am ringing the bell……we have seen the lows for this year in long-term rates and it’s time to lock all long-term loans…..short-term rates will continue to decline but unless inflationary expectations decline it will be nearly impossible for long-term rates to go much lower. The 10-year US Treasury was at 3.38% and now one month later is at 3.90% an increase of 52 basis points. Can you afford NOT to have this information each day?

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Fed Chairman Ben Bernanke will speak on Wednesday morning at 7am to the House Finance Committee and the financial world. Markets are seeking guidance from the Fed head but the last two years have shown the Fed is frequently following rather than leading economic policy. With commodity prices rising (Minnesota wheat over $20/bushel) many are forecasting a 1970’s stagflation which ended when Paul Volcker earned his inflation fighting honors in 1980-1985. Unfortunately Big Ben doesn’t have the same choices as Mr. Volcker in raising short-term rates. The Fed has cut the overnight funds rate by 125 basis points in 2008 to its current level of 3.00%. If the Fed could influence long-term rates (it can’t) the US economy might stand a decent chance of rebounding back into trend growth (2.5% real GDP). The Congressional stimulus plan will have rebate checks in mailboxes soon and much like the bounce after “Katrina” consumer spending will pick up along with paydown of credit card debt. This will give the appearance that we have hit a bottom in the economy and home prices but it’s nothing more than a ledge that will break within 1-2 years. The Fed’s greatest fear is not inflation which is a lagging indicator but of DE-flation which is always caused by a contraction in credit. It takes two parties to create a loan, a borrower must believe he can earn a return higher than the interest paid and the lender must have the funds to lend and hope they will be paid back with monthly interest. Recessions begin when only one player is missing but a depression is a certainty when both are nowhere to be found. The Fed is in a box and doesn’t know how to stimulate demand for money (borrowers) or increase the supply of funds (lender) but the Fed head is sure to hear many suggestions on Wednesday from politicians running for office in a few months. My suggestion is to add magician David Blaine to the FOMC as a special consultant in charge of solving this most difficult problem. The Fed must move quickly as Mr. Blaine is scheduled for another death defying challenge in May of this year. He will attempt to break the world record for sleep deprivation. I could help him with this stunt as reading 27 newspapers each day, dozens of blogs, running a full time charity, writing a daily newsletter and a few other necessities leaves me with very little sleep each night.

Spanning the globe

With gold soaring ($941 today) and trader sentiment over 90% bullish I found it interesting to see my Economics 101 rule taking effect in India. An article this morning quotes the president of the Bombay Bullion Association with the fact that India’s gold imports fell to 5 tonnes last month from 62 tonnes in January 2007. Jewelry shops across India are reporting a fall in sales as buyers are pulling back because of high prices. When prices of a commodity rise sharply supply increases and demand decreases unless there is a perception that supply is unable to be found. Why is oil hanging at the $100 barrel level? Oil is not created overnight and the longer it stays at current levels the more long term production/exploration we will see over the next few years.

My third best bet for this year was the commercial real estate market would enter a severe bear market taking away the headlines from the residential sector. An article in today’s Washington Post shows that only 18 percent of new office space under construction had been pre-leased by the end of 2007. With the commercial mortgage market frozen (only one CMBS deal this year) and long-term rates rising, prices will begin to fall in the next couple of months. Unlike the home market, commercial prices are driven by lending rates and higher borrowing rates drive sale prices lower. We are now seeing the first signs of non-performing commercial mortgage loans and many more are on the way. The government will have its hand full with home mortgages and will not be able to get involved bailing out commercial investors and banks. Although the Fed is happy that the yield curve is positive (my #1 bet for 2008) giving banks the ability to borrow at the 3% funds rate and lend at much higher long-term rates it is worried that higher long-term rates will have a negative impact on the US economy’s ability to grow (jobs and income) The Fed is again caught as it tries to help banks build balance sheets but faces a head wind that may blow the roof off many lending institutions.

An article in today’s NY Times written by former Fed Vice-Chairman Alan Blinder proposes a 1930’s style solution to the massive housing problem. Is the government prepared to take over ownership of 5 million homes? Unlike the 30’s the problem is not just about monthly mortgage payments but a much more serious issue of declining home prices (deflation). Again, the Fed is faced with a problem…how can it create house price inflation without bleeding through to the entire economy? This might be more than David Blaine can handle…..

Would you like to adopt a vacant house? In Minneapolis city leaders are encouraging people to adopt houses near their homes. I’m not sure this idea will grow as homeowners have enough of their own problems and will look to city government for assistance especially with high tax rates.

I wrote about frozen equity lines a few weeks ago but a Saturday article is another example of the growing credit contraction. For any economy to grow it must have an ample and easy to obtain supply of oxygen (credit). Homeowners have used their Heloc’s as an ATM machine for the past few years and this has fueled consumer spending. With home values decreasing lenders are attempting to reduce their risk by cutting off any unused credit. This is a smart move for lenders but will have a devastating impact on borrowers who had NOT yet used their credit lines but assumed they would always be available for medical, child tuitions or living expenses in case of job loss. America has lived way beyond its means for the past 20 years and now is faced with forced savings as borrowing avenues are all but the most secure borrowers who probably don’t need the credit.

A lucky Georgia couple won the Mega Millions lottery on Friday evening (100MM+) but the biggest winner of the year might be a man who hasn’t made a payment on his 1.5 million mortgage since 2002. His lender failed to prove that it owned his mortgage and has ended its attempt to foreclose on his house. How did he become so lucky? Home mortgages are being sold every few months by lenders as they attempt to maximize their dwindling liquidity. You can’t make a loan if you don’t have any funds so the originate to distribute model has become as popular as the Monopoly game still sold in stores. In the past judges would accept the “word” of lenders stating they owned these loans. Today the lenders must show proof and many of the lenders have lost (or never had) the proper paper work. Although many will try and play this ultimate lotto ticket I expect most lenders to tighten their internal controls considerably to prevent other homeowners from winning the big prize.

Interest rates are falling and rising

My best bet of the year is for a widening yield curve with the 2-year falling (2.10%) and the 10-year rising (3.90%). Mortgage rates are soaring as lenders increase their spreads when rates fall and keep margins flat when rates fall. Heads they win and tails they tie…not bad but necessary when you are barely in business. This week the twins (Fannie and Freddie) will announce their quarterly earnings and the whole world will see what this letter has warned for months….the GSE’s (Government sponsored enterprises) are severely under capitalized for what they are being asked to do (underwrite more mortgages). They need to be GOE’s (government OWNED enterprises) and have an unlimited ability to clean up the mortgage mess which will take years. The coming bounce in home prices and economic growth is nothing more than a pause in the worst US economic contraction since the early 1930’s. For those that did NOT sell their real estate holding last year this rally will offer one last chance to exit before the next leg down that will leave very few standing. When history looks back upon this era it will tell a sad story of millions who were NOT prepared for a storm that was easy to forecast but difficult to prepare for because so many see the future only from their own experiences.

The Fed is pushing on a string

Have you ever thrown a party but none of the invited guests attended? Fed Chairman Ben Bernanke must have many sleepless nights as his anxiety level increases with every Fed interest rate cut. In the old days (1980’s) Fed policy frequently influenced the direction of long-term interest rates. If the Fed eased or tightened long-term interest rate markets assumed the Fed knew the future rate of inflation and economic growth. This gave the Fed enormous power to create the solution to any economic imbalances, loan demand, consumer spending, etc. If the US economy was slowing down the Fed knew that a few cuts in the overnight rate would be followed by a reduction in long-term rates which could stimulate borrowing and create a rebound. In the last few years the Fed has lost much of its power (and credibility) as Chairman Greenspan became frustrated with the lack of upside movement in long-term rates during the Fed’s 2004-2006 tightening of policy. While the overnight Fed Funds rate rose from 1.00% to 5.25% the 10-year Treasury rate rose from 4.00% to 5.25%. Mr. Bernanke is surely seeking a way to drive long-term rates lower in an effort to reduce borrowing costs for homeowners that still have equity but can’t afford their monthly mortgage payment. Last Thursday (2/14) the 10-year rate rose to 3.81% which is 50 basis points higher than the 2008 low (3.31%) set on January 22nd. With the new higher limit on conforming loans (729M) soon to be implemented it would be very embarrassing to the government if borrowing rates were actually higher for the new conforming borrowers. The yellow flag continues to fly with no green flag in sight as long-term rates rise in defiance of current Fed desires.

The biggest bull market of the year

Gold? Wheat? Rice? What has been the biggest winner of 2008? Rarely is anyone lucky enough to hit a grand slam in their first at bat of the season. The first 2008 issue of the EWW forecast a widening yield curve as the Best Bet for the year. Our belief that short-term rates (2 yr.) would decline and long-term rates (10 year) would rise came from the fact the Fed was caught in a must ease mode while long-term rates are NOT influenced by Fed policy. On January 8th the spread between the two treasury rates was 108 basis points. Today the 2-year trades at 1.90% and the 10-year at 3.76% for a spread of 186 basis points or a gain of 78bp or 72.2% in six weeks. With no signs of the Fed ending its march to 0.00% in the overnight rate and long rates climbing despite good news this spread should easily surpass 200 and then 250bp before the end of the year. With the inflation component of the 10-year holding stubbornly at 2.27% the Fed is desperately trying to jump start the economy without the benefit of lower long-term rates.

Mortgage lending and the new conforming limits

Mortgage brokers, real estate agents and homeowners are hoping and praying the new conforming limits help to reduce monthly mortgage payments. Currently jumbo 30 year rates are approx. 100 basis points higher than those on currently conforming loans (417M). SIFMA (Securities Industry and Financial Markets Assoc.) announced Friday these ”new” conforming loans would not be eligible for inclusion in the already existing conforming loan pools. Instead they will be securitized under unique pools that will most likely be priced well above current conforming loan rates but slightly less than current jumbo rates. The most important part of the stimulus bill that has received very little press is the provision allowing for the “new” conforming limits to apply to loans made after July 1,2007. This is extremely important for banks that have current jumbo loans on their books and will now be able to sell these to GSE’s (Fannie Mae & Freddie Mac) thus freeing up badly needed capital to make more loans to new borrowers. Of course the big question is where will the GSE’s find the $$$ to make these new loans? Their excess capital is near zero and they may be forced to offer guarantees to these mortgages instead of actually being able to purchase new loans. We won’t know most of the answers to the mortgage questions for at least 30+ days but the long-term interest rate market will not be waiting as it continues to trade upward driven by confusion over future inflation rates and Fed policy.

Blood, Sweat and Tears

“What goes up, must come down, spinning wheel got to go around, talkin’ bout your troubles it’s a cryin’ sin……you got no money, you got no home…” the words from a famous BS&T song from 1969 that ring so true today. Real estate and home prices that have defied gravity for years finally have begun their descent to earth with craters everywhere from the crash that no one has ever seen before unless you were alive during the 30’s. It is so easy to say “I’ve seen it before, real estate always rebounds” or “it’s never a bad time to buy real estate.” Can agents ever be objective? How? Isn’t it easier to lose in company than win alone? Although a bounce is ahead and followed by the rebates from helicopters we are nowhere near the end to the mortgage massacre that began for real last year. If this was really a blip we would be recovering already but the cost of credit (interest rates) is irrelevant if banks won’t lend at any price.

Bear markets take many years to wring out the excesses from the previous cycle only ending when the last few hanging on throw in the towel and promise to never play again. As many readers are aware I read 27 newspapers daily and dozens of web blogs. Last week had a few quotes that are worth reviewing to give us an idea where we are in the current cycle. From Friday’s San Bernardino Sun a 20-year veteran realtor said: “Sellers keep reducing the price, but they are always too late.” “The current housing meltdown has a different twist to it than prior slumps.” “Last time we had some equity on properties, but this time there is NO equity.”

From the Santa Rosa Press Democrat on bankruptcies: A BK judge said: “I’ve never seen anything like this before and seen so many people care so little about losing their homes.” Of course they care but they see that values are falling and they have no equity…unless the government takes over their homes and rents back they have no choice.

Can prices stop falling? Sure but first we need to see an end to new construction. From the Chicago Tribune a story about rising inventory levels and booming construction of new units. In Downtown Chicago purchases of new condos in 2007 were 3,783 but over 6,000 new condos will be completed this year. How can prices stop declining if supply is rising faster than demand? Why is this happening? Easy answer, we only see life from our own experiences and every decline in real estate prices in the last 30 years has been followed by new highs. Until this bear breaks everyone’s spirits and belief that it is always a good time to buy or the NAR’s advertising campaign that real estate prices always rise over a 10-year period we will continue to go one step up and two steps down. Just because you made your fortune in real estate doesn’t mean the market owes you anything……or will repeat so you can make $$$ again.

This week

CPI and housing starts on Wednesday are the key economic stats but the interest rate market is focused on credit availability, liquidity and the stock market. Short term rates will continue to fall and long rates will hold to a slightly rising trend. A widening yield curve is the safest and least risky play as it continues to hit new highs each week.

Lenders and borrowers that don’t want to dance

This year’s credit contraction continues to pick up steam as lenders are afraid of loaning money that may not be returned and borrowers are afraid they won’t be able to make the monthly payments. Normally a recession is caused by high interest rates and tight lending conditions that are alleviated by lower interest rates and a willingness of banks to lend. But this year’s version is something most of the world has never seen before and hopefully will never see again. The Fed’s recent cuts in the overnight Funds rate to 3.00% have done little to stimulate demand from borrowers or supply from lenders. Many believe the mortgage problems lie in the sub-prime area and can be fixed with lower interest rates. Unfortunately sub-prime represents only a small part of the credit contraction as the word deflation is about to make a comeback in many cities across the country. Home values and soon commercial real estate values are the elephant in the room that no one really wants to discuss. Congressional action last week was swift with the stimulus bill now awaiting the President’s signature. Real estate professionals are like shoppers waiting for store openings the day after Thanksgiving as they await hoped for lower mortgage rates for the new conforming limits. This may stimulate demand for homes over the next few months and will certainly free up much needed capital for banks as the new conforming limit is retroactive to July 2007. This demand will serve as an excellent vehicle for homeowners to sell and avoid the next leg down in this real estate bear market that will leave scars for decades.

The elephant in the room is not leaving and will teach the vast majority of homeowners the most powerful economic lesson of their lives: The past is not always a good predictor of the future. Yes every drop in home prices over the past 30+ years has led to higher prices but this bear market will not end until every real estate agent learns the hard way that it is NOT always a good time to buy real estate. It will be many years before we see a solid bottom and that will be followed by years of little or no appreciation in home values.

Mr. Bernanke goes to Washington

Thursday morning (2/14) Fed Chairman Bernanke gives his Valentine’s Day forecast before the Senate Banking Committee. The Fed head is in a no-win situation as the Fed has only 3% more they can lower the overnight funds rate. If they lower the Funds rate to 0.00% and demand doesn’t increase for loans the Fed will be powerless at a time they will need to show leadership to a very frightened world. The one consistency over the past 2 years is the markets have been slow to realize the severity of the mortgage and economic problems. The stock market’s January drop did force the Fed’s hand (1.25% in two weeks) and will soon rally with higher real estate prices but the economy is headed south until banks become lenders and consumers replenish savings and confidence. I often write that the vast majority of investors and homeowners would rather lose in company than win alone. How many took advantage of this downturn in real estate and made $$$? Do you know anyone? Do you know any real estate agents that told their clients to stay away for a few years? How could they and still make a living? You can’t short real estate (bet on lower prices) so it is almost impossible to be objective about price trends. The best to hope for is that today’s price is lower than last year’s but that doesn’t mean it can’t be lower next year and the year after, etc. Thousands of homeowners are being wiped out of their net worth because they believed that the past is always a predictor of the future. It’s a very sad day for America.

The yield curve and the yellow flag

My best bet of the year continues to rise like a rocket ship as the 2-year Treasury is at 1.90% and the 10-year at 3.61% for a spread of 171 basis points. One month ago (1/08) I wrote this spread would widen from 108 to over 200 and we are more than half way to the target. Why speculate on the actual level of rates when the spread is a much safer way to play the game. Long rates have seen their lows for this cycle at 3.31% (10-year) on January 22nd but the Fed is not even close to the end of its easing as the Funds rate could easily be lowered to 1.00% or less. With the world looking to Mr. Bernanke on Thursday for direction and leadership it is obvious he has no idea when this contraction will end or how to slow its decent. The Fed can only offer lower short-term interest rates and have NO control over long rates.

The British Pound

This was our 2nd best bet for 2008 as we forecast a much lower Pound and with the Bank of England cutting its overnight rate last week by 25 basis points to 5.25% this currency has begun its fall to the 1.80 level later this year. Job layoffs and housing price declines in England will force the BOE to follow the Fed with much lower short-term rates.

Commercial real estate

Our 3rd best bet for the year was a collapse in the commercial RE market as the financing part of this market is frozen and shows no signs of thawing this year. Unlike home purchases this market is heavily driven by financing rates as they are an integral part of the total return to the investor. Most in the lending industry are hoping and praying for a return to the “old times” but without government intervention it has very little chance of occurring and will have a devastating effect on the overall economy.

Summary

Congratulations if you are still reading as the news is not good BUT the next few months will present an opportunity to those that have yet to leave the party hoping prices would rebound. It won’t be much but something is better than nothing and our three best bets are star performers so far in 2008. Remember the markets owe us nothing and have no memory, because you made $$$ in real estate in the past does NOT guarantee the future is going to repeat. The big winners over the next few years will be those with low debt and big savings and as usual these winners will be in the minority. Change is not easy but those that embrace this new era of economics will live to fight another day while those that lose in company will not survive.

The train has left the station and is picking up speed

Rarely is timing perfect in the very difficult world of forecasting but this letter’s forecast on January 8th (see archives) was surely our best of the year. With a Fed in panic mode and easing 125 basis points in the last two week the yield curve (10 year – 2 year) has widened to another high of 152 bp. With more Fed easing expected this spread should widen to 200bp or more in the next few months. Friday’s job news was both discouraging and confusing for anyone trying to decipher the direction of the US economy. On the surface the 17,000 decline in payrolls should send a strong message that the economy has slowed and entered a recession. But, the Labor Dept.’s monthly seasonal adjustment (birth/death model) subtracted 378,000 jobs from last month’s number and without this adjustment jobs actually rose significantly. Increasing the confusion the BLS revised December up 64,000 and November down 55,000. It is painfully obvious that the government has no idea how many jobs are being created each month and this indicator has become useless in any forecaster’s toolbox.

Why are interest rates falling?

Interest rates are set by the demand for money by borrowers and the available supply of funds by lenders. Normally when borrowers need funds they drive the price higher (interest rate) but this is anything but a normal economic cycle. Many banks would like to lend but they don’t have the available funds due to the fact that mortgage loans previously originated and sold in the secondary market have been “put” back to them. When a bank originates and sells a loan it expects the loan to stay with the buyer but because of the high default and delinquency rate of borrowers these loans are being sent back to the original lenders. Banks need to set aside reserves for every loan that remains on their balance sheet so most banks attempt to earn “fees” that come from the sale of loans. This increases profits and doesn’t require reserves to be used as a back up for any originations. This is somewhat difficult to explain but the important point is that as rates move lower it is NOT creating increased demand for funds by borrowers and that is DEFLATIONARY. Economics 101 tells us that as prices fall we see a pick up in demand and when prices rise supply increases which drives demand lower. This is NOT occurring today and the Fed will soon learn that lower short-term interest rates are not the answer to jump start the economy and consumer spending. After a small bounce this year in real estate prices and the GDP we will begin the next leg lower in 2009 and that will cause a major spike higher in the unemployment rate and force the government into massive intervention as panic takes over in Washington.

Do you have an unused credit line against your house?

Last week we saw the beginning of a very disturbing trend by lenders to cut off credit to thousands of homeowners. Countrywide sent a letter to many of its Heloc customers stating that they were going to suspend draws of further funds indefinitely due to declining house values. Many homeowners have home equity lines as a backup in case they lose their job or need funds for an emergency. Most lenders approved these credit lines with combined loan to values of up to 90%-100% never even considering that a home price could decline. Lenders are afraid their loans are about to go from collateralized to uncollateralized and that is not only dangerous but requires more reserves (see above). The biggest problem I see is that if a homeowner has the ability to borrow against a credit line that once funded will make the total amount owed greater than the value of the house they have no incentive to stay in the house and make monthly mortgage payments. We have seen a dramatic increase in foreclosures and a suspension of credit line availability would drive homeowners to abandon their homes and use the credit line $$ to rent an apartment. The lenders are clearly caught in a no-win position. Last year I wrote that the government may have to assume ownership of thousands of homes and then rent back to these people. This is a problem that is not going away soon and until home prices stabilize it will aggravate the mortgage problem. Short-term interest rates could go to 0.00% and it won’t help anyone if house prices continue to fall.

Global warming in China?

Has anyone noticed the weather around the world? It recently snowed in Jordan and China causing massive damage to electrical equipment. China has a massive power shortage due to a price freeze on electricity prices imposed in September as the government tries to cool inflation fears by mandating low prices. Price fixing never leads to a lowering of the inflation rate but does lead to a run on materials and Chinese coal reserves are at record lows.

The Pound is heavy…

My 2nd best bet for 2008 was that the value of the British Pound would fall sharply and Friday’s US jobs news sent the Pound tumbling from 1.9950 to 1.9700. The Bank of England will soon be forced to lower short-term interest rates and that will create a stronger US dollar. Real estate prices in the UK have begun to drop and I expect the US economic contraction to spread quickly to our other trading partners. Global decoupling is not here yet and the old adage that when the US catches a cold the remainder of the world catches pneumonia is still true.

Conclusion

The Fed will continue its “panic” easing of short-term interest rates but long-term rates hit their low on January 22nd with the 10-year at 3.31%. The yield curve will continue to widen and that will drag the US dollar higher. The US economy will see a mild rebound later this year before its next major leg down in 2009. The commercial real estate market is the next time bomb set to explode as the financing part of this market is completely “frozen”. Borrowers are waiting and waiting for lenders to come out of hibernation and it won’t happen for a much longer period than anyone expects. Remember that we only see life from our own experiences and no one has ever experienced what we are about to see in this country over the next 24-36 months. Liquidity is the key…stay out of debt and accumulate cash for the opportunities that lie ahead in the near future.