You no doubt have had at least a few moments of doubt and concern at the recent stock market volatility. The bad news is that stock markets are ultra–sensitive to bad news, such as the recent turmoil in the subprime mortgage market. The good news is that the kind of volatility we’ve seen over the past few months is probably not a sign of economic apocalypse.
Remember Easy Money?
Anyone with a mortgage, credit card, or new car is well aware that credit conditions have been fairly easy for the past five or six years. As recently as a few months ago, the world was still awash in liquidity.
Then came the “subprime meltdown.” The time line went something like this:
In response to recessionary conditions in 2001, aggravated by the events of September 11 and the bear market, the Federal Reserve began injecting liquidity into the economy. It did this by buying bonds from banks with money that it prints for just this purpose. This act of monetary policy is commonly referred to as cutting interest rates, but the Fed doesn’t actually control interest rates. It alters the money supply so that it outstrips demand, thus causing interest rates — the price of money — to fall in the marketplace.
The banks took this surfeit of cash and began making loans, many to homeowners and home buyers. When the good credit risks had their fill of low–cost loans and cash–out refinancing, the banks began to target riskier or “subprime” borrowers. At the height of the credit boom in 2004, the share of subprime loans went from 4% of total lending to a whopping 10% of total lending. 1
This spike in subprime loans, since dubbed a bubble by some commentators, helped stimulate demand for real estate by increasing the pool of eligible buyers, which in turn helped drive up home prices.
Adjustable Woes
Many subprime loans were made with adjustable rates that offered appealing introductory rates but would later adjust upward, perhaps more significantly than many buyers anticipated. Many loans were also given to buyers who were not required to fully document their incomes (45% of subprime loans went to such buyers in 2006), allowing some to borrow more money than their creditworthiness might have allowed in less heady times. 2
During this time, home prices were rising so rapidly that borrowers who were having trouble making payments could simply refinance, keeping defaults artificially low. This may have masked the true risk of loaning money into the subprime market, causing the major credit–rating firms to possible overrate the credit quality of some subprime mortgage debt. 3
Wall Street and Main Street Banks
This crisis might have garnered less attention on Wall Street were it not for a recent sea change in the way the mortgage market is organized. In the past, banks were the most common originators of mortgages, and federal deposit insurance encourages depositors not to make a run on their banks when they get in trouble. But after the savings and loan crisis in the late 1980s and early 90s, banks were required to keep more capital in reserve against subprime loans.
This shift in the regulatory landscape helped foster an environment in which non–bank mortgage lenders flourished. Unlike banks, which lend depositor capital, these newer lenders relied on credit from Wall Street and the “securitization” of their loans. Wall Street was so eager to buy mortgage loans from banks to sell to bond investors that even the demand for subprime mortgages spiked. Then, when adjustable rates adjusted upward, some subprime borrowers could no longer make their mortgage payments. As a result, subprime defaults have fallen less on banks than on bond investors who may not have understood the true risks of investing in subprime mortgages. When one of the nation’s largest subprime lenders was forced into bankruptcy in early 2007, leaving its shareholders to help absorb the loss, it created uncertainty about the future of the subprime business and, by extension, the global availability of credit. 4
Fear and Loaning
The current fallout in the financial markets is less about what has happened so far than about the fear that subprime situation might be a sign of more defaults to come. This fear has caused a reluctance among investors who buy loans. Lenders need to sell their loans in order to raise funds to keep lending. Investors began refusing to buy mortgage–backed securities that were once thought to have unquestionable worth, opting instead to lock up their cash in safer short–term Treasury debt. 5 This caused a dearth of credit–market liquidity, notably in the commercial–paper market, which is a source of short–term funds for a broad range of companies. These companies rely on such short–term funds to finance operations, and a shortage could slow economic growth, the fear of which is responsible for some of the stock market volatility we have been seeing.
Fed to the Rescue
These developments led the Fed to decide it needed to step in to help restore confidence. The Fed’s early response was to cut the interest rates on the discount window, which is traditionally considered a last resort for banks needing to borrow money. Banks normally don’t like to borrow from the Fed because it can be expensive and casts doubts over a bank’s solvency. By assuring banks that they could continue to borrow against their outstanding mortgages without impugning their reputations, the Fed was able to help restore some confidence, at least in the short term, in the credit markets, and thus the rest of the financial world. 6
In addition, other central banks around the world, notably the European Central Bank, began pumping cash into the financial markets through inexpensive loans to commercial banks. 7
Federal Reserve officials have stated publicly that the subprime problems should remain contained and there is no evidence that they will spill into the prime mortgage market or the broader economy. 8 So far, the evidence bears this out: The actual number of subprime loans in default is but a fleck in the sea of mortgages. Of the 44 million outstanding U.S. mortgages, less than 14% are subprime and about 13% of these are late on payments. In all, about 0.06% of total U.S. mortgages are in default, up slightly from the 0.05% rate in 2006. 9
Red October
However, an unusually high number of variable–rate mortgages were scheduled to reset in October 2007, when an estimated $50 billion in mortgages will adjust upward from their introductory rates. Thereafter, an estimated $30 billion worth of adjustable mortgages will adjust each month until September 2008. One analysis has predicted about 1.7 million households could lose their homes.10 A flood of foreclosures and fire sales could further depress housing prices.
Still, many market observers seem fairly confident that the housing market is unlikely to cause a bear market or a recession because the rest of the economy remains strong.11 Nonetheless, we can probably expect the stock and bond markets to take some more time to become comfortable with shifting credit conditions.
Lewis Walker is President of Walker Capital Management Corp. and Walker Capital Advisory Services, Inc., a Registered Investment Advisor (R.I.A.) Securities and certain advisory services offered through The Strategic Financial Alliance, Inc. (SFA). Lewis Walker is a registered representative of SFA which is otherwise unaffiliated with the Walker Capital Companies.
1) NRO Financial, August 14, 2007
2–4) The Wall Street Journal, August 7, 2007
5–7) The Wall Street Journal, August 20, 2007
8 ) The Wall Street Journal, July 25, 2007
9) NRO Financial, August 8, 2007
10–11) The New York Times, August 1, 2007
Posted by bondsblog as Financial Planning with Lewis Walker at 7:44 AM EDT
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As we near the month- and quarter-end on Friday, we look to several upcoming data releases and the 5-year supply for trading direction. The $18 bn in 5-year Treasury supply will likely lead a concession in the sector — either outright or on the curve. In addition, we expect that incoming data will provide some interim trading direction, although we retain our bullish bias for the longer end of the curve as duration demand picks up.
The overnight session failed to provide any sustain trading direction despite the strong bid for Asian equities overnight — the Nikkei and the Hang Seng each gains 2.4% — in an impressive showing. And while this performance weighed on JGBs — with 10-year yields increasing 6 bps, the carry-through to our market was very limited, illustrating the growing disconnect between Treasuries and the lingering global growth.
We have been asking ourselves — what does it take to get the market to leg higher from here? While we have no definitive answer, its clear we need positions to extend from the current flat positions as real money provides some sponsorship — yesterday’s release of the weekly Stone & McCarthy survey shows that this trend has continued — the index printed at 100.7% of the duration-weighted benchmark, unchanged from last week. We take some solace in the fact there remains ample room for another leg higher should the market shift higher, though there is a notable absence of any short-base to create a covering-bid.
The market has favored a consolidative trade for much of this week — building up some solid volume points in the current range — a potentially supportive sign for the market. That said, we are starting to shift focus to next week’s series of data — ISM, ADP, and the all-important Employment report. Next Friday’s NFP and UNR combination holds to potential to reset expectations for more fed cuts in the near-term if it prints weak, but the risks are asymmetrical in that a strong report will be dismissed as noise.
TACTICAL BIAS: We like the market into the end of the week and expect that as the month- and quarter-end approaches we will retain a bid further out the curve. The front-end of the curve has performed well despite the supply — impressive by our read. We hold our steepening bias into the end of the week, but caution that the strength of the duration grab may provide the strongest challenge to this play.
Thursday offers some new information and another round of supply — $13 bn 5s.
We get the final revisions to second-quarter GDP — which is expected to come in slightly lower. Equally as interesting are the updated reads on Initial Claims and New Home sales — both key subjects that continue to drive price action in this market, so we look for further confirmation of slowing in the housing market and any insight on the labor market.
Fedspeak has not been credited with any price action so far this week, and we have slim hopes that will change today — when we hear from Paulson, Bernanke, Mishkin — but with topics of Climate Change, Integrated World Economy, and Globalization, respectively, we look for few tradable comments. The Chairman’s comments will not have a released prepared text or Q&A.
IMPENDING EVENTS:
* GDP Q2 Final Revisions, +3.8% consensus vs. +4.0% prior print.
* GDP Price Index Q2 Final Revisions, +2.7% consensus vs. +2.7% prior print.
* Unemployment Claims, 320k consensus vs. 311k prior.
* New Home Sales Aug, 835k consensus vs. 870k July.
* Help-Wanted Index, Aug 24 consensus vs. 25 July.
* $13 bn 5-yr note auction
OVERNIGHT EVENTS:
* Asian Equities surged — following late-day strength in US. Nikkei up 2.4% and Hang Seng gains 2.4% as well — weighing on JGBs 10-year yields increase 6 bps.
* German ILO Unemployment edged lower — 6.1% Aug vs. 6.2% July — slightly lower than the consensus call for unchanged at 6.2% — marginal improvement in the labor market, but unable to drive price action.
* Several German State’s reported stronger CPI: Saxony +2.6% YoY vs. 2.0% prior, Hesse +2.3% YoY vs. 1.6% prior, and Brandenburg +2.4% YoY vs. 1.9% prior. Added little selling pressure to EGBs or Treasury.
* UK Nationwide house prices stronger than expected in Sept +0.7% MoM vs. +0.3% consensus and +0.6% in Aug. YoY 9.0% vs. 9.6% Aug. On
* China Securities Journal reports the new Chinese sovereign wealth fund will start operations on Sept 29th — $200 billion in capital.
NOTE: The views expressed are not of Bonds.com but of the unaffiliated author. Bonds.com makes no claim to and regarding the accuracy, correctness or completeness of the views expressed.
Posted by bondsblog as Morning Call at 7:41 AM EDT
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Federal Reserve Bank of Philadelphia President Charles Plosser said last week’s interest-rate cut could cause inflation to accelerate and that policy makers must be ready to reverse course if needed.
“Cutting the funds rate has the potential for aggravating inflation, there’s no question about that,” Plosser told the New Jersey Technology Council late yesterday. Should inflation or price expectations rise in coming months, “the outlook will be affected and policy may have to be adjusted.”
Plosser, who doesn’t vote on rates this year, is the first official to express concern about the Fed’s Sept. 18 decision to lower the benchmark interest rate by a greater-than-forecast half-point. The reduction, while “appropriate” because of slowing job growth and falling home prices, shouldn’t lead to further moves unless data become “much weaker,” he said.
“I will not be surprised to see weaker statistics,” Plosser said in the speech in Mount Laurel, New Jersey. “But weaker numbers will not lead me to revise my outlook or my view of the appropriate funds rate target unless they are much weaker than already anticipated and accumulate sufficiently to generate another downward revision in my outlook.”
The Federal Open Market Committee unanimously voted to reduce the rate on overnight loans between banks to 4.75 percent, the first cut in four years, aiming to keep financial-market turmoil from ending the U.S. economy’s six-year expansion.
Traders expect the Fed to lower the rate a quarter-point at each of the next two FOMC meetings, on Oct. 30-31 and Dec. 11, based on futures prices.
`Appropriate’ Move
“A slower economy means that real interest rates must decline to bring about the appropriate adjustments to restore growth,” Plosser said. “In recognition of this, I believe last week’s action to lower the fed funds rate target was appropriate.”
Economic reports yesterday bolstered the case for the Fed to keep cutting rates. Consumer confidence slumped to the lowest level in almost two years, a Conference Board index showed. The National Association of Realtors said August sales of previously owned homes dropped to the weakest pace in five years.
Two-year Treasury note yields declined 2 basis points to 3.97 percent as of 7:49 a.m. in London. Against the euro, the dollar traded at $1.4128 in London and reached $1.4162, the lowest since the European currency’s debut in January 1999.
Plosser’s remarks contrast with comments by other Fed officials since the Sept. 18 decision. Chairman Ben S. Bernanke and Vice Chairman Donald Kohn didn’t mention risks from the rate cut in remarks last week.
Asset Prices
Bernanke told lawmakers the move was designed to “try to get out ahead of the situation, try to forestall potential effects of tighter credit conditions” on the economy. Kohn said in Frankfurt that the central bank was motivated by the potential for asset-price shifts to affect growth and inflation.
Plosser, whose anti-inflation remarks have been among the Fed’s toughest since he joined the central bank last year, had expressed skepticism about the economic risks from financial turmoil 10 days before the Fed meeting. While the surprise loss of U.S. jobs in August was “not encouraging,” it didn’t on its own justify lowering rates, Plosser said Sept. 8 in Hawaii.
The Labor Department said Sept. 7 that employers cut 4,000 workers in August, the first drop in four years.
Yesterday, Plosser said the June and July job-growth figures, which were revised lower, were “more troubling” and suggest the labor market “may not be quite as tight or as robust as we previously thought.”
Rebound in Growth
At the same time, “there is also the possibility that growth will rebound more quickly than is now anticipated,” he said. “If so, and the outlook is revised upward, monetary policy makers will have to reassess” policy, he said.
Plosser, who votes on rates for the first time in 2008, emphasized that “price stability is and should be the primary focus of monetary policy.” Officials “must resist the temptation to respond to short-term, transitory disturbances” unless they affect the Fed’s long-term goals, he said.
Plosser, 59, is a former professor and business-school dean at the University of Rochester who took the helm of the Philadelphia Fed bank in August 2006. He was previously co- chairman of the Shadow Open Market Committee, a group of economists that critiques Fed policy and has traditionally favored keeping inflation close to zero.
The risks from the rate cut underscore the need to have a public, numerical inflation goal, a topic debated by Fed officials for the past year, Plosser said. It’s not the exact target for inflation, that matters, he said, but the idea that the Fed has a stated “commitment.”
Separately in yesterday’s speech, Plosser said the economy can expand at about 2.75 percent annually over the next few years without stoking inflation. He estimated longer-term productivity growth at “slightly below 2 percent.”
To contact the reporters on this story: Scott Lanman in Washington at slanman@bloomberg.net ; Anthony Massucci in Mount Laurel at amassucc@bloomberg.net .
To view the original article, click here.
Posted by bondsblog as FED Watch at 7:58 AM EDT
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