The information below indicates trends and is not a predictor of what rates are going to do in the future. You might tend to agree or disagree with the information below. This is not Cypress Mortgage's opinion nor my opinion. Many of us look at trends and have established opinions of our own, supplying data to back up your opinion is important and here is some data that supports these observations.
Last Friday
A day that will go down as a historic day in US economic history. The Fed stepped in at 6am and announced http://www.federalreserve.gov/boarddocs/press/monetary/2007/20070810/default.htm 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. Friday morning's loans were made for the typical three day period and must be renewed or rolled over on Monday morning. Friday's action was not unprecedented and one which has been 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. Many of us 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 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.
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."
The yen continues to be the best barometer for world market health and last friday 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 http://www.earlywarningwire.com/S&P500 vs. yen.pdf 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.
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 to 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.
It's been long forgotten but just three days ago the FOMC announced http://www.federalreserve.gov/boarddocs/press/monetary/2007/20070807/ 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) http://www.bloomberg.com/apps/news?pid=20601087&sid=aGF91P.1DJgc&refer=home 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 in the Interest Rate Update you saw 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.
One of the answers to our financial problems may come from China. 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 http://www.telegraph.co.uk/money/main.jhtml?xml=/money/2007/08/07/bcnchina107a.xml 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.
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. Friday 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 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 http://www.verifyemployment.net 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.
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 does the market really care 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
Liquidity is important for everything in life and the markets. If we don't drink enough water each day we become dehydrated which in some cases can be life threatening. If the markets don't have liquidity (the ability to buy or sell without big price movements) they tend to create high volatility which leads to a difficult environment for businesses to operate. Yesterday's stock decline (300+ pts.) was clearly a liquidity event caused by the market that is controlling almost all of the worldwide markets: the yen. A couple of weeks ago in the Interest Rate Update it felt different as the US stock market reached new highs and the yen failed to hit new lows. In the last week the yen rose from the 122 level to 118 (panic buying). It's extremely important to remember that markets move quickly when the majority of leveraged participants are losing money and must rush to exit positions for fear of not having enough capital to fight another day. Initial positions can be entered using patience but when one is losing the exit door needs to be found quickly and before everyone else breaks down the door. The "yen carry" trade has been the key driver in 2007 as hedge funds and anyone else seeking a "low risk" way to make profits has borrowed yen (under 1% borrowing rate) and then converted the yen to high yielding currencies (Australia, New Zealand) or strong stock markets (US) or anything else that is solidly moving in one direction. Unfortunately for those caught yesterday the only safe haven was US Treasuries as many investors find it to be the best resting place until we see the level that stabilizes the yen. Mortgage market update On March 23rd (see archives) in the Interest Rate Update the quote: "Soon we will see the prime mortgages priced at higher spreads to treasuries and it would NOT surprise anyone 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." If you are in the mortgage or real estate business you are acutely aware that mortgage rates have not dropped anywhere near as much as Treasuries in the last month as lenders do exactly as predicted: they have widened their lending spreads in an effort to increase profits to offset losses from their sub-prime, alt-a and every other product they have sold to customers but not been able to sell to the street fast enough to avoid losing money. There are few advantages of growing old and it’s called "perspective." If you were around in the late 70's/early 80's and saw interest rates moved 50 basis points in a few hours and the Fed made changes to the funds rate in the middle of the day (decision made by telephone). The 1987 stock crash (caused by Greenspan's insistence on holding up the value of the dollar) saw extreme volatility and more painful lessons for the rookies that had never seen this scene from a movie that many of us had viewed before. You have read here many times that we only see life from our own experiences and the blood in the mortgage market is being spilled from those that refuse to believe that the world is anything but the way they have experienced. Whether it be margin calls to lenders with warehouse lines that were more than enough in the past few years or just a feeling that the lending tree could grow to the sky it is very difficult to break away from the pack and leave the party before the authorities arrive with the paddy wagon. People would rather lose in company than win alone. Very few people were smart (or lucky) enough to take their chips off the table and walk away early despite the fact that they could be ostracized by their friends, business partners, etc. Long term winners are never afraid of anything and Sam Zell looks like a genius for his sale earlier this year of his Equity Office Partners to Blackstone. Bear markets are unusual and almost unheard of in residential real estate. For the past two years the Interest Rate Update has over and over and over again noted that this would be the most unusual decline for real estate in history. Unlike the past 30 years we would not see every small decline in prices met with buyers that would drive prices to new highs. Those real estate agents that said: "I have seen everything, nothing could be as bad as the early 80's" laughed told this would be very different: a long, slow, painful decline that would last a minimum of 5-7 years. Despite what everyone is hoping for we are still at the very beginning of this decline with a few months pause to be followed by more pain in 2008. Look for the stated income loans to soon be replaced in the mortgage marketplace by the old fashioned full doc loans back at the forefront of the mortgage products offered by the dwindling number of lenders. If stated income loans do survive it will be only for loans with very low LTV's. Credit scores have proven not to be a good barometer of a borrower's ability to pay and having studied the history of market meltdowns (and up) it is clear that we always have an over reaction in the other direction after the smoke clears. Regulators and the government move slowly and will want to make sure the housing market is never able to repeat the events of this year again (at least in their lifetime) so the change to tighter underwriting guidelines is also just at the beginning. One of the reasons that the price of residential real estate must continue to fall comes from Virginia. Earlier this week an article pointed out that home prices continue to be priced at a level where the monthly mortgage payment is greater than the needed income of area buyers would need to qualify for a loan. "To buy a $600,000 home, a buyer would need at least $120,000 cash as the down payment. To cover the roughly $3500 monthly mortgage payment, the buyer would need a pre-tax, household income of about $95,000, said Eric Compton, mortgage broker with Salem Financial. The median household income in the Roanoke Valley is about half that, limiting the pool of potential buyers." Last year this could have been an easy stated income loan but now it needs full documentation and won't qualify. Strap on your seat belt, big changes are on the way. http://www.roanoke.com/business/wb/wb/xp-125142 Interest rates On June 1st the Interest Rate Update: "Until the yen rises to the 118 level (yesterday) the US stock market should have clear tracks to travel faster and faster and faster speeds until its ultimate hard correction similar to its February 27th pit stop." Obviously yesterday's 311 point Dow drop qualifies as a hard correction. Nothing has changed the relationship between the yen and the US stock market, it doesn't pay to try and guess the day the link breaks, just watch it daily and it's actions will speak volumes to us about the future. One June 8th the Interest Rate Update: “Nothing has changed with the forecast of lower rates once we pass the July 4th holiday. Pessimism is building in the press with Pimco chief Bill Gross writing on his website yesterday that long rates will reach 6.50% in the next few years. Interest rate speculators are increasing their bets on higher rates and the best way to create higher prices is for shorts to be set at lower prices and yesterday's heavy volume shows that many lenders threw in the towel and hedged their positions at what will soon be seen as too late. It is said that the average person forgets over 90% of what we experience each day in just 3 weeks. With a declining memory it is imperative to review the past 85 years of rates to stay ahead of the crowd. When everyone was panicking (especially in the press) justo go back into history of data and charts and calmly conclude that the stage was being set for an explosive rally in bond prices (rates declining) and not to panic. It looks like interest rates are getting ready to break hard below 5.00% on the 10-year...the market acts very short, the yen isn't falling, more stocks made new lows yesterday than new highs.....it feels like the bond market wants to erupt like a dormant volcano... Where we are going from here.... The US 10-year Treasury is currently trading at 4.78% and is probably headed for the 4.50% level. This proved to be formidable resistance earlier this year (March 13th - 4.49%). The Fed clearly does NOT want to lower the Fed Funds rate (ease) as it would be a clear admission that the US economy is much weaker than forecast. Fed Chairman Bernanke has stated that the housing problem would not have a material impact on the economy and this morning's 2nd quarter GDP number (+3.4%) has calmed the markets at least for a few hours. The strength in the economy is clearly coming from an increase in exports to countries not suffering from a home/mortgage problem. The stock market was hit hard yesterday and after a few days of higher prices (next week) should test yesterday's level again in August. The recent action in oil is of interest. Oil acts well and clearly wants to make a run for the $80 level (especially at the sign of an August hurricane) and only sold off yesterday when the stock decline created forced selling of every other market as investors were raising cash to meet margin calls. The Interest Rate Update last week raised the yellow flag and would come down after we saw two weeks of trading under 4.98% on the 10-year and that is surely coming next week. The only hesitation with the bond market is the fact that the recent rally is being led by the short end (5 yrs and under). Long lasting rallies (lower rates) are almost always led by the long end (10 yrs. and over) and that is the part of the curve the Fed watches closely along with the inflation component. If the short end continues to lead then the Fed will be forced to ease and that will cause a rush into Treasuries which will push rates towards the 4.00% level. The long end is probably watching to see if the consumer cuts back on spending and then translating to a higher unemployment rate. Pay close attention to the daily value of the yen and the relationship between the short and long end of the yield curve. If the long end begins to lead we will soon see a move to the 4.50% level on the 10-year. The recent increase in volatility will be with us for the next few months and agility will be important for those of you that need to lock loans or play in these risky markets. The Interest Rate Update is NOT an investment newsletter and everyone should consult your professional advisor before making any decisions that could affect your wealth or income. Bottom Line: Interest rates are acting exactly as we said they would earlier this year and should extend their decline over the next few months. The fuel for the continuing decline will be the news of a slowdown in the US economy accompanied by an inflation rate of under 2%. The shorts (see above) that were set by mortgage lenders and others betting on higher rates have not been fully exited and that should allow us to see lower rates soon. The icing on the cake will be if the next phase of the bond rally is led by the long end. Next week brings a lot of economic news headlined by Friday's (8/03) jobs report and the interest rate market is focusing on any news other than from other markets (yen, stocks, etc.). The monthly employment release from the BLS has lost much of its credibility due to a faulty seasonal adjustment (birth/death model) but the unemployment rate will carry weight with the Fed if it begins to move higher over the next few months. Personal income, spending and inflation indicators come Tuesday morning (5:30am) and might be helpful if they showed a marked slowing in spending or inflation. The big date for August will come on Tuesday the 7th as the world will anxiously await a Fed statement that should include some mention of this week's meltdown in the mortgage lending market.
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