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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 week was an extraordinary week for interest rates and Fed policy and for the last four days. The world markets have put on quite a show since Tuesday.  The fact that the markets are real 24-hours a day as they process what has happened, what they believe will happen in the future and most importantly act from their past experiences. We only see life ahead from our own past experiences.

The Fed and Libor

This past Tuesday the Fed caught up with economic reality when it lowered the Fed Funds rate by 50 basis points to its new target level of 4.75%. It really had no choice as the Libor rate had jumped in the last few weeks to far above its normal level versus the funds rate. Most of the press noted the Fed ease but somehow forgot to inform everyone that market rates were soaring on the news and only banks borrow at the Funds rate. Most variable rate mortgage loans and some fixed rate loans are tied to the Libor rate not the Funds rate so borrowing costs had actually risen in the past month for many homeowners. Of course the Libor rate rose due to a lack of transparency in the credit markets for asset backed collateral and even with the Funds rate cut we see the 3-month Libor rate trading today at 5.20% instead of a more normal 4.85% or lower. Six month Libor is 5.09% but that rate is almost 50 bp above where the market believes the Funds rate will be in December. It's important to note that Libor is NOT one rate, there is a dollar/Libor, yen/Libor (1.00%), Euro/Libor (4.74%), Pound/Libor (6.365%) etc. and they all trade independently of each other.

How often do we get a 2nd chance to back up the truck?

As most of my long-term readers are aware, if  they read the interest rate update for the first half of 2007 that interest rates would begin a serious decline in the 2nd half of this year.  Most bull markets leave potential passengers at the station without another point of entry as everyone waits for the pullback that never arrives and only enters when the train is nearing its final destination. The bond market's reaction over the past 3.5 days to the Fed's change has been violent as the 10-year has risen 24 basis points and a total of 38 in just the last 8 trading days. When the 10-year was 4.32% the world was in a panic and fearing further credit problems and now with the 10-year close to 4.70% the world sees nothing but inflation storms on the way. How could expectations change so much in eight days? If the Fed had lowered the funds rate by 25 basis points would the markets have reacted similarly? What about no change in the Funds rate? Can markets filter information that quickly and see the future clearly?

The answers to these questions are not easy but must be answered to see clearly where we are going in the next few months and into 2008-09. Let's begin with former Chairman Alan Greenspan whose new book was released this week and who has made more TV, radio, newspaper, internet video appearances than any Presidential candidate this year. He even made it to Comedy Central ( http://www.comedycentral.com/motherload/player.jhtml?ml_video=102970&ml_collection=&ml_gateway=&ml_gateway_id=&ml_comedian=&ml_runtime=&ml_context=show&ml_origin_url=/shows/the_daily_show/videos/most_recent/index.jhtml&ml _playlist=&lnk=&is_large=true ) after his initial appearance on 60 Minutes. If you are having trouble sleeping than his book is a must read. We learned a few things that are somewhat interesting such as his favorite economic indicator is the sales of men's underwear and that he wrote his best speeches in his bathtub. The most important point that the markets have clearly not understood is that the Bernanke Fed is NOT in any way similar to the Greenspan Fed. After 19 years in office the world financial community became familiar with Greenspan speak and actions from the Fed although at the beginning in 1987 there was much confusion due to everyone believing he was going to act like his predecessor Paul Volcker. Chairman Greenspan picked up a reputation for always bailing out markets when it seemed they would plunge further with some perceived disregard for the inflationary consequences.

Our main focus is on this week's bond market reaction to the Fed change in policy. Using Greenspan history as its guide, bond investors sold and sold more this week and decided that they would analyze current economic events at a later date. Has anything changed? Of course not, the funds rate decrease actually confirms that the economy has entered a recession (6/07) and that consumer spending is about to drop off a cliff as the never say die US shopaholic family is on life support. With the home mortgage ATM window closed to the average borrower we are seeing a dramatic increase in credit card debt as many homeowners try to hold on even at 15%+ interest rates. Businesses appear to be borrowing (http://www.federalreserve.gov/releases/h8/Current/h8.pdf) according to weekly Fed reports but its temporary as commercial paper lines are being extinguished due to the lack of disclosure in the pricing of many pieces of collateral. Last week commercial paper outstanding fell another $48.1 billion with only $15.6 coming from asset-backed (mortgages) securities. Over the past 5 weeks CP has fallen $263.4 billion (12.8%) with $205 coming from asset backed paper (-19.4%). The so called experts see a strong economy due to heavy loan demand from banks but aren't factoring in the decline in CP that is causing a rush to the bank lending window.

This week's pull back which could easily go to the 5.82% level on the 10 year (50% retracement of June/September move) gives us another outstanding opportunity to back up the truck and lock in what will soon be seen as high yields. For borrowers the good news is that rates are headed much lower but unfortunately spreads may not follow as credit quality issues will be with us for the next few months. The ultimate frustration for real estate borrowers will be a decline in Treasury rates that does not bring a reduction in spreads so they must find ways to lock in these lower rates (under 4%) using other vehicles.

Falling home prices

According to an analysis by Moody's (http://money.cnn.com/2007/09/19/real_estate/steep_home_price_drops_coming/index.htm?postversion=2007091915) home prices will decline by up to 25% (Stockton) over the next 1-2 years. Most people seem to be focusing on buying under the theory that real estate prices always rise over time but recent events may show that those entering the market now will suffer a decline in their equity before seeing any appreciation in later years. A story from today's Miami Herald (http://www.miamiherald.com/news/breaking_dade/story/245102.html) details an auction last night that brought lower prices for newly built condos. In May, a one-bedroom brought $360,000 but a similar condo sold last night for less than $220,000. The best quote in the article is: "Many people who bought a few months ago are now upside down. The place isn't worth what they borrowed, & next week or the week after, look for lawsuits on this building." Last week in this interest rate update you read about a sale by Hovnanian (homebuilder) and today's Sacramento Bee (http://www.sacbee.com/142/story/390800.html) reports 47 homes were sold in the California Capital. I'm sure the prices were much less than existing sellers were offering and that is going to create a BIG problem for homeowners trying to find buyers. Home builders must get rid of their inventory so they can replenish their capital and do this by lowering home prices. They are in business and what doesn't sell quickly gets sold at much lower prices. The typical homeowner doesn't see it as a business and is much more reluctant to lower prices so they are always following the market and for the next few years it will be down, down, down.......

The final insult for condo owners is that we are seeing more "reversions" - where condo buildings are converted into apartment buildings - than at any time since the early 1980's. The good news is that rental rents will soon decline giving consumers more to spend or save but for the condo owner it probably means higher borrowing rates as lenders don't like to give lower rates unless the building has at least 60% owner-occupants.

Conforming vs. Non-Conforming

Mortgage brokers and borrowers will soon have good news as Congress will most likely pass legislation raising the limits on conforming mortgages (probably 50%) from its current level of $417,000. Initially it may only be a temporary move but rarely does Congress take something away from taxpayers in an election year. Fannie Mae & Freddie Mac will also be allowed to purchase more mortgages but the main beneficiaries will be those whose loans can be underwritten at full principal and interest payments. In a Thursday hearing before the House Financial Services Committee, Fed head Bernanke and Treasury Sec'y Paulson both admitted that for the vast majority of underwater homeowners nothing can be done because they couldn't afford their mortgage payments when they purchased the house and now are upside down because of a drop in home values. The only way out is for Congress to allow banks to take over the houses and rent them back to the home owners with an option to buy back if values increase or they win the lottery, etc.

Summary

The Fed's action this week is simply a catch up to reality and nothing more. The contagion from the mortgage market will continue to spread to the overall economy and consumer. Yes, the dollar's decline will help narrow our trade deficit and soften the blow to those companies that receive the majority of their revenue from exports. Interest rates have NOT seen their lows for this cycle and those looking for an explosion from inflation will be disappointed when they realize the economy, real estate prices, and consumer spending entered a recession in June 2007. As usual this Interest Rate Update stands alone in its forecast with not much cover but as we like to say: The majority would rather lose in company than win alone. The risk/reward of a bet on lower rates offers tremendous opportunity to those willing to stand alone.