The Largest mortgage lender in the world......The Federal Reserve

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.

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 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.

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 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.

The Fed

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.

China

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.

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. 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.

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 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