Mortgage Rates climbing but NOT because of rising inflation

This morning Freddie Mac released its weekly survey of residential mortgage rates and announced they have risen to levels not seen in a year.  A 30-year fixed rate loan averaged 6.63% and the chief economist for the agency said it was because of market concerns about rising inflation and expectations that the Fed will raise short-term rates later this year. It amazes me that these so called “experts” continue to mislead the public with information that is far from accurate. Mortgage rates are higher because Fannie and Freddie have increased fees and spreads on loans they purchase as they desperately attempt to stay alive and away from a complete federal government takeover.

Inflation

It’s important to analyze the recent trend in long-term interest rates and let’s begin with the fact that the 10-year Treasury rate (4.01%) has two components representing a real rate of return (1.68%) and inflation component (2.33%). These numbers can be viewed each day at Bloomberg.com by subtracting the 10-year TIPS yield from the actual 10-year rate and arriving at the inflation component. On June 16th the 10-year reached its peak for this year at 4.27% and the inflation component was 2.53% (representing investor’s inflation expectations for the next 10-years). On July 10th the 10-year fell to 3.80% and the real rate was 1.36% (representing investor expectations of economic growth over the next 10 years). The 10-year had fallen 47 basis points in less than a month but most of the decline was due to reduced expectations of economic growth NOT a lowering of inflationary expectations. Today with the 10-year at 4.01% the inflation component is at 2.33% down 20 basis points from its level of a month ago. I know this is a lot of numbers and data but the bottom line is that inflation expectations are FALLING even though long-term rates have risen in the past few weeks. You can find these numbers yourself each day and not have to believe what you read from the economists who have missed the majority of the housing crises and interest rate move lower. In May 2007 (see archives) we saw almost the exact same situation with a dramatic rise in long-term rates to 5.30% on the 10-year with forecasters saying it was because of rising inflation fears when the actual numbers told a very different story. Oil has pulled back sharply in the past few weeks and this has had a positive impact on future expectations of inflation. Long Treasury rates have risen because expectations the U.S. economy will soon be growing at a faster rate WITHOUT rising inflation. Higher oil prices are NOT inflationary if consumers spend less on other goods and services while spending more on gasoline purchases. 70% of inflation is created through higher wages and we are not seeing wage inflation at this point in the economic cycle and with a rising unemployment rate many will soon be faced with accepting any job available at a low wage rate. It’s simply Economics 101, when supply (jobs) increases relative to demand (slowing business) prices (wages) go lower.

The Fed

The second part of today’s press release by Freddie Mac spoke about a greater probability of an increase in the overnight Funds rate this year. It is very doubtful that the Fed will raise short-term rates this year and with unemployment rising, house values falling and credit impossible to obtain for almost everyone why would the Fed RAISE rates? Strengthen the dollar? Doubtful.  That is what caused the stock market crash in 1987 and forced us into a depression in the early 1930’s. It has been over a decade since Fed interest rate movements had any effect on long-term rates. In fact one of former Chairman Greenspan’s greatest frustrations was that long-term rates did NOT rise when the Fed raised rates from 2004-2006. He said many times he wanted long rates to rise to curtail loan demand from homebuyers. Long-term rates are a function of inflationary expectations and frequently go in the opposite direction of Fed Funds movements. The Fed would need to increase the Funds rate if loan demand was soaring but it is almost impossible for the average borrower to obtain credit today because banks can’t lend what they don’t have and it will take many years of a positively sloped yield curve for them to create enough profits to begin lending again. Credit continues to contract each week led by the real estate sector and when accompanied by declining asset values has always led to DEFLATION.

State economies (50 stories)

Never in our history have we seen such divergence in the direction of individual state economies. A report from the National Conference of State Legislatures shows that “states that have significant portions of their tax bases tied to natural resources seem to have escaped major budget problems.” With home values declining many counties are being forced to reduce property taxes and that will soon cause tremendous strain on municipal budgets and force federal government support. The one employment category that is sure to increase in the next five years is from government agencies that will be used to increase regulation in the mortgage/lending area and disburse billions in government assistance to state and local governments that will declare bankruptcy without the help.  Texas continues to lead the way in job opportunities and wage growth and saw an increase in construction jobs last month. For those seeking opportunities in multi-family buildings Texas offers one of the few bull markets remaining in the commercial real estate sector.

The Fed’s Beige Book which analyses economic activity in each Fed District had a few interesting tidbits in yesterday’s report. Regarding the cracking commercial real estate market the Boston Fed described conditions as “morose”, a word I couldn’t find ever used before in this report. If conditions deteriorate as I am sure they will what word will they use? The Cleveland Fed reported smaller banks receiving more deposits as a result of a flight to safety by investors. My concern is whether these are brokered deposits of under $100,000 to take advantage of the safety net provided by the FDIC. This could be a major problem in 2009-10 if investors flood into weak bank CD’s at higher than market rates due to the guarantee by a government agency. Regarding inflation worries many Fed districts forwarded comments from companies that “sluggish demand has made it difficult to raise prices.” If customers believed inflation was coming soon they wouldn’t care about current prices because of fears that prices were sure to be higher next year.

Has anything changed?

I began the year (see archives) stating this would be a slow developing bear market for real estate prices and that the commercial market would begin a nasty decline which is exactly what is now occurring throughout many parts of the U.S. The federal government has stepped in with $100+ billion of stimulus checks which were mostly used for gasoline purchases and other non-luxury items. A 2nd stimulus program may soon be needed but in an election year it might be difficult to reach a consensus from Congress. I am stunned by the lack of concern for the economy from both Presidential candidates, they act like it is a typical election year and are clearly not prepared for the carnage we will soon see as bankruptcy and unemployment rates soar to levels not seen for decades. My biggest worry is that the majority of people continue to act as if they have seen this play before and the last act ends with the economy roaring back to normal growth due to lower interest rates, easy credit and government help. How could anyone believe anything other than from their own experiences? Counter trend rallies in stocks and rates will convince many the worst is over and one must remember the sharpest and most violent rallies always occur in the worst and longest bear markets. The best advice is the most difficult…pay down debt, de-leverage, increase savings…the best investment opportunities are ahead but they will arrive in a years not months.

Return OF capital not return ON capital is the key to success as the credit contraction picks up momentum and the best investment idea for the remainder of the year.

The past week has been painful for almost every sector of the U.S. economy with continued oil price hikes, the failure of the 2nd largest bank in U.S. history, a stock market decline to new lows for the year and questions about the survival of the twins (Fannie and Freddie). EWW readers (growing every week) should not have been surprised at recent events as we have warned of the impending credit and liquidity crunch for the past two years even though being right about bad news brings no friends just reluctant acknowledgement and hopes that our forecast will soon call for clear skies. Unfortunately we are in the beginning stages of the worst credit contraction seen since the Great Depression of the 1930’s. Major changes in the economic and political landscape will take place in the next few years as the de-leveraging of American businesses, lenders and consumers has devastating effects on the way we see the future. Fasten your seat belts as the ride is going to be similar to a roller coaster at an amusement park without the thrills.

The Fed

It is amazing how market perceptions change so quickly and lose sight of the major trend because we often project our own needs onto market conditions. We do see the future from our own past experiences and since 99.99% of investors did not witness the early 1930’s they can only hope it will not be repeated. Early this year with the stock market plunging and Bear Stearns being bailed out (except the common stockholders) the consensus view was for the Fed to lower short-term rates to zero and open borrowing facilities for any and all lenders. Panic and fear were at extreme levels in March and the Fed did manage to create enough liquidity to temporarily calm the waters. One of the most difficult patterns to detect is the one that is rarely seen and today is a long-term bear market. It is slow, vicious with violent counter trend rallies and doesn’t end until everyone has left the playing field with vows never to return. The Fed bought time and breathing room as spring ended with relative calm (similar to after an earthquake) but one must remember after shocks are frequent and remind us of fault lines under the surface that are not easily repaired. Debt creation was one of the main causes of the real estate bubble and once it peaked is very hard to restart the process similar to putting toothpaste back in a tube. Not surprisingly since lower short-term rates have always solved every past economic problem investors and consumers assumed (incorrectly) that history would repeat and along with fiscal stimulus (IRS rebate checks) the economy would bounce quickly and would be back on the road to wealth we enjoyed over the past many years. In early June market players were 91% confident of a Fed increase in the Funds rate at its August 5th FOMC meeting. This was more hope than reality as the dollar’s decline was blamed for the price hike in oil and the old game of hiking interest rates to attract hot currency flows (similar to high bank CD rates) was picking up momentum from Wall Street analysts. Doesn’t anyone remember what caused the 1987 U.S. stock market crash? If not, review the recent happenings in Iceland where the central bank increased its overnight rate to 15%+ in an effort to stem outflows from an economy addicted to foreign deposits. The level of overnight rates in the U.S. is somewhat irrelevant today as banks can’t lend what they don’t have and underwriting policies are so tight the only way to obtain a loan is if you are in better financial shape than your lender. There is one important reason the Fed MUST not raise short-term rates and in fact needs to lower the Funds rate to 0.01% (similar to Japan a couple of years ago) and that is to help its member banks repair their balance sheets. Despite $350 billion in new capital injected into banks over the past year (with massive dilution to shareholders) many large banks are on the verge of insolvency as the value of the collateral (real estate) for their loans continues to decline and borrowers go into default.

The majority of banks will survive this turmoil and this presents a once in a lifetime investment opportunity for investors. The Fed will use its most powerful tool to create badly needed profits for its member banks. It will continue to keep short-term interest rates low (below the inflation rate) thus allowing banks to borrow at 2% (current fed funds rate) while lending at much higher long-term rates. If banks can’t find worthy secure borrowers that meet the new tougher underwriting guidelines they will send their low cost $$ to the U.S. Treasury and purchase notes and bonds which yield much higher returns. The yield curve (relationship between long term and short term interest rates) has entered a long term bull market phase where the spread will widen to all time record levels and remain there for many years. What about inflation? The dollar? Foreign investment in the US? All important items but a credit contraction is a rare event not often seen in anyone’s lifetime and it brings the most evil of all threats to an economy…DEFLATION. Like a virus, it spreads slowly but deep into the decision making process of a country, and only leaves when credit becomes available and is used by business and investors.

At this point you probably are wondering if I am delusional as inflation appears to be the problem today due to rising oil and commodity prices. An increase in price levels is inflationary only if demand increases as people believe they need to accumulate items for future use because we will never see today’s prices again (similar to the 1970’s). Isn’t this the reason most people bought houses in the late 90’s? Fear of not being able to afford a house in a few years led people to buy before they actually needed (space, family, etc) or could make the monthly mortgage payments. I often heard the quote from real estate agents that there is “never a bad time to real estate” and the average person saw rising prices and believed that they would continue to rise. The availability of credit to anyone breathing created the demand and it became a self fulfilling prophecy. The same thing occurs on the downside as prices fall, credit tightens, prices fall more and the cycle continues for many years. The only way to stop the fall is through bank lending and banks need capital to lend, without it momentum builds and demand drops which leads to more price level declines and that is DEFLATION.

My best bet for the next 12 months is a play on the Fed giving banks every chance to build up their balance sheets and stay alive….a widening yield curve. It’s easy, you don’t have to watch it every day and a year or two from now the rewards should be huge to patient investors.

Covered Bonds

The mortgage market has suffered many devastating blows in the last 12 months and most wholesale residential mortgage brokers will be seeking new jobs in another field soon but some good news is on the way for banks that originate retail loans. With Fannie and Freddie representing almost 90% of loans closed in the 2nd quarter due to a lack of available funds by banks a new funding source will appear soon creating liquidity for lenders and more borrowing outlets for buyers of homes.

Covered bonds began in Europe around 1770 and represent senior debt obligations of a financial institution that are secured by a pool of loans that remain on the bank’s balance sheet. Buyers of these bonds have recourse to the issuer (banks) and the underlying pool of assets (mortgages). With over a trillion dollars outstanding (mostly in Europe) the U.S. has never embraced this idea due to Fannie and Freddie’s dominating presence in the marketplace. One of the concerns among investors has been what happens to the collateral if the underlying bank goes into receivership. The FDIC cleared the way earlier this week by giving bondholders access to the collateral in the event of bank failure. We will soon see an explosion of these types of bonds in the next couple of years but this only applies to residential mortgages and only those that were completed using “full doc” programs. The days of stated income loans are gone for a very long time. What makes this new type of financing so easy is that the mortgages always stay on the balance sheet of the issuing bank but the yearly interest is paid from bank cash flow and not the mortgages so there is no pre-payment risk to the bond holder. Of course if the bank does fail the bonds will be paid off early through liquidation of the collateral.

Fannie and Freddie have huge solvency problems and the common shareholders will most likely be wiped out if the government does step forward and inject capital or lend them funds. Covered bonds will soon be able to take a great deal of pressure off the twins and allow them time to also regroup and replenish their capital. None of these events will happen overnight and the next couple of years will be painful for most investors, homeowners and consumers as the de-leveraging of America continues to wipe out billions in wealth that was created in the last decade. Good investment opportunities will be rare but betting on government intervention and increased regulation will give you a better chance of survival and return ON capital at a time when most will be wishing for a return OF capital.

Will Daddy allow the twins to go under?

Uncle Sam’s favorite twins (FNMA & Freddie Mac) saw their stock prices fall sharply this week amid fears they won’t be able to raise new capital needed to continue their lending business. The only advantage of old age is the memories of past eras, many of which today’s younger generation only read in a history book. Remembering that we only see life from our own experiences I vividly remember the mid-80’s when another of Uncle’s Sam’s step-children (Federal Farm Credit Bank) was rumored to be on the verge of insolvency due to depressed farm land values and diminished capital. The FFCB was never allowed to fail on any obligations even though one Federal Land Bank in Mississippi needed a multi-billion dollar bail out by the government. Shares of Freddie fell 23% today and Fannie 13% I find it impossible to believe either one of these government sponsored entities would be allowed to fail on any of their debt obligations. Common stock holders might find their equity dramatically reduced or wiped out as the companies are nationalized as a last resort.

For the past two years I have written that we are entering a vicious, long and deep bear market led by a credit contraction not seen since the early 30’s. In March Fed Chairman Bernanke told the world that credit was the oxygen our economy needed to grow and we are now seeing the initial stages of a downtrend in credit. The Fed’s weekly H.8 report reported a dramatic $21.6 billion decline in real estate loans for all commercial US banks. Although this number may be revised it is important to note that real estate loans represents over 50% of all bank credit and the total is now below the amount we saw in February of this year. We know there has been debt contraction in the residential part of this market but are now witnessing commercial problems from shopping centers and office buildings. For the first time since 1980 more space (3.2 million sq. ft.) became available to rent at strip malls than was being rented out in the 2nd quarter and average vacancies rose to the highest level since 1995.

In past cycles we had credit tightening when the Fed raised overnight interest rates and more expensive credit had a limiting effect on borrowers’ desire for funds. 2008 has brought the eye of the storm to the U.S. economy as declining asset values and an inability to lend (no $$$) has created the proverbial “fire in a theater” with a mass run by borrowers to pay down debt and deleverage. Unfortunately many can NOT pay down debt as the cost of gasoline and other commodities has forced them to use credit cards for purchases but that window will be closing shortly as lenders simply run out of money to lend. Revolving credit (credit cards) growth rose 7.22% in May from a year earlier and would be rising faster if lenders were still sending applications to anyone with a pulse. The difference for lenders is that credit card interest rates are much higher than for residential loans so their losses from defaults will be offset by the profits from those that are able to make monthly payments.

Interest rates

As everyone is aware the Fed controls short-term interest rates (Fed Funds) and the market determines the level of long-term rates. The U.S. 10-year note closed trading today at 3.81% almost an exact 50% retracement of the move from 3.31% on March 17th to the recent high of 4.27% on June 16th. During this time market expectations went from more Fed easing to an increase in the Fed Funds rate later this year. This was based on fears of rising inflation due to oil and other commodities and misplaced feelings that a declining dollar is the cause of inflation. The recent decline in the 10-year rate has come as a result of $$$ fleeing from the stock market and a sharp drop in the inflation component of the 10-year from 2.61% to 2.47% in just the last 3 trading days. As long as we see this rate stay below its high of 2.72% set in 2005 inflation will be a temporary problem but the bigger problem is that DEFLATION always follows a credit contraction. The only way we can have sustainable inflation is through wage growth above 4% per year. The 1970’s stagflation is being forecast for a repeat but that era saw wage growth far above the “key” 4% level and heavy inventory accumulation due to near certainty of price increases in materials that were sure to be used in the coming years. 2008 is NOT a repeat of the 70’s but closer to the 30’s but since very few experienced that era they only expect what they witnessed 30+ years ago.

Summary

Trends tend to go on for much longer than anyone ever expects and unfortunately many in the real estate and mortgage area are about to learn a very painful lesson. History does repeat but not when expected and trying to catch a falling knife usually ends with the blade creating blood instead of the rewards if they caught the handle. The end of this sad chapter in economic history will only end when the majority of players leave the arena due to exhaustion of capital and energy. Only when people learn that the risk of winning alone is a better strategy than the safety of losing in company will the economy begin a long slow upward grind. Mortgages will soon be nationalized, increased government regulation has entered a new bull market and tax rates are sure to rise no matter who wins the presidential election. Fasten your seat belt as the bumpy ride continues for at least the next 3-5 years. In the last chapter of this saga the BRIC’s (Brazil, Russia, India and China) will be forced to invest their billions & trillions of dollar reserves into the U.S. as they realize without the US consumer their increased production of goods and services has no end buyer. Opportunities exist for those with cash and a long term view but the old ways of making money through leverage and a heavy debt load are gone for at least the next decade.

The 2nd half of the year brings another opportunity for a home run

In our first issue of the year I wrote about a widening U.S. yield curve (10year-2year) as the Fed was forced to lower the overnight Funds rate. At the 108 basis point level early in January we saw a dramatic steepening in the first three months of the year as Fed easing overwhelmed bond traders and sent short rates plunging to levels not seen in many years. The curve did break the 200 level in mid-March after the Fed was forced to arrange a merger for Bear Stearns but a subsequent rally in oil fueled expectations of an imminent Fed tightening. Recently the curve fell to the 120 level and now trades just under 140 basis points with the 2-year at 2.58% and the 10-year at 3.96%. Big profits occur when the majority is wrong and the consensus forecast from the “experts” is that the Fed will need to raise the overnight Funds rate by the end of the year to support the falling dollar. Although high CPI (retail inflation) numbers are expected in July and August (high gasoline and commodity prices) demand is falling rapidly as Economics 101 shows us demand always falls as prices rise.

Unlike the ECB (European Central Bank) which is mandated to only fight inflation and is widely expected to raise its overnight rate to 4.25% Thursday morning, the Fed is required to balance inflation and the economy. With oil at $143+ inflationary expectations are rising and the inflation component of the 10-year Treasury trading now at 2.58% any pullback in oil and /or rise in US stock prices will send bond rates soaring back to the 4.25% level seen in June. Once traders realize the Fed can NOT raise short rates due to rising unemployment and economic weakness the yield curve will widen dramatically as long rates rise due to a temporary increase in the inflation rate.

Credit = Oxygen

The uptick we are seeing in inflation will prove to be transitory as this is nothing like the 1970’s when we witnessed the historic stagflation that led to sharply higher short-term rates in the early 80’s. Fed head Bernanke is learning that having studied history is helpful but not the key to success as head of the world’s biggest central bank. He has spent the last 2+ years trying to please everyone inside and out of the Fed instead of focusing on what is needed to make sure history is NOT repeated with a depression similar to the early 30’s. The key is credit and its availability to borrowers and lenders. Past credit crunches were accompanied by higher short-term rates with the Fed attempting to make loans more expensive but not cut off their availability. Today we have falling asset prices ($2.1 trillion drop in stock values this year) and a severe shortage of money for banks to lend. The bank side of this problem is correctable but will take many months/years and can occur only with a steep yield curve where short rates are much lower than long rates. Banks can raise capital by selling shares as prices continue lower but the best way to increase lendable funds is by increasing profits and that can only occur when the cost of funds for banks is much less than the rate they charge borrowers. Ben Bernanke is well aware of the role he must play in the coming years and is trying to engineer a plan that will insure low short rates that will allow banks to become lenders again. This may need government assistance through the form of a nationalization of mortgages as the Fed’s balance sheet is now loaded with lower quality paper instead of the Treasury bills and notes it had just a year ago. Total Federal Reserve Credit is now falling at a pace not seen since 1948 and that will help slay the inflation villain later this year. Income levels are not growing anywhere near what is needed to pay for rising gasoline and commodity prices and the ensuing reduction in demand will create lower prices for other discretionary goods and services. A year from now the problem will be DE-flation as rising unemployment, credit contraction and stagnant earnings will lead to a major cutback in consumer spending and increase in savings as fear grows that the rebound predicted for 2009 has been delayed until 2010-2012.

The counter trend rally in the US economy arrived right on schedule with the $100+ billion in stimulus checks hitting bank accounts over the past 2 months. Much more will be needed as legislators realize their re-election is in jeopardy from a constituency that has plenty of time to vote since they are now unemployed. Thursday’s jobs numbers will again show a net decline in workers and an unemployment rate headed for the 6-7% range later this year. We have spent the past decade free of much government interference in markets but that is about to change dramatically no matter who is elected President. The consensus is about to change from the “I hope this will get better in 2009″ to “will this ever get better?” Bear markets are vicious, long and don’t end until the vast majority have left for other jobs, businesses and investments. It took years to get into this mess and it will be many years before we are able to begin the march back up the mountain of wealth. Memories are the most important part of our decision making process and far too many are hanging on believing the past will repeat with $$$ waiting for those with patience but it is not to be as we are all going to learn that history does repeat but not when we expect.

Conclusion

The economy is in the early stages of the worst economic contraction since 1932 and as consumers see their reality change spending will decrease and savings will begin to build. Real estate buyers will learn the hard way that being too early is painful and without the ability to obtain credit many will be standing in an increasing unemployment line next year. The answer will come from the federal government as it is forced to offer aid to state and local governments and taxpayers who have exhausted all available remedies. Tighten your seatbelts as the upcoming ride will be the bumpiest anyone has seen in their lifetimes. Very few profit from a bear market but those that are not afraid to win alone rather than lose in company will survive and thrive in the next couple of years.