Market Review: Financial Crack-Cocaine

Ben Bernanke, in his first speech as the new Chairman of the White House, assured the public that the Bush administration is closely monitoring the housing market.

Now, that certainly makes us feel better, dear reader. We can all sleep a little better tonight knowing that the world-improvers in Washington are on the case. But what, pray tell, are they doing? How exactly, are they "monitoring" the housing market?

First, by denying that there is really any problem. Bernanke said, "While speculative behavior appears to be surfacing in some local markets, strong fundamentals are contributing importantly to the housing boom…those fundamentals include, low mortgage rates, rising employment and incomes, a growing population and a limited supply of homes or land in some areas."

He goes on to say, "The administration will continue to monitor developments in the housing market. However, our best defenses against potential problems in the housing markets are vigilant lenders and banking regulators, together with perspective and good sense on the part of the borrowers."

Bernanke, who could fill Greenspan’s shoes as Fed Chairman when the time comes (a scary thought), is having way too much faith in borrowers. Good sense is not something that neither the lender, nor the subprime borrowers involved in this "frothy" market have in abundance.

"If you are a stockbroker, you don’t put grandma into a hot tech stock. In the mortgage market, you may have a product that is perfectly O.K. for a thoracic surgeon or a professional basketball player, but is not appropriate for a nurse at Baptist Hospital in Winston-Salem," said Joseph A. Smith Jr., the state banking commissioner of North Carolina.

Little action has actually been taken by the banking regulators, although a NY Times article tells us they have "signaled their discomfort about the explosive rise in risky mortgage loans."

But why would they want to step in? The Fed has a good time making macroeconomic policy – who wants to worry about the pizza delivery guy who just bought a $300,000 house?

Although some small steps are being taken for more scrutiny into potential home-purchasers background; from the Fed to the Office of Comptroller of the Currency, the federal banking regulators have not backed up their warnings with any sort of major interference, because they wouldn’t want to stand in the way of a new method of lending, or more "financial crack-cocaine," as our Pittsburg correspondent would put it.

"We don’t want to stifle financial innovation," said Steve Fritts, associate director for risk management policy at the Federal Deposit Insurance Corporation. "We have the most vibrant housing and housing-finance market in the world, and there is a lot of innovation. Normally, we think that if consumers have a lot of choice, that’s a good thing."

Yes, more choices, and more ways to Super-size our debt, that’s exactly what Americans need. God forbid, we would put regulations out there that may "stifle" the mortgage lenders’ creativity.

Even so, some analysts feel that the mortgage industry has hit its top with their pièce de résistance – the ARM. "No other product can compete with the low monthly payment of an option ARM…even interest-only loan products fall short."

Douglas Duncan, chief economist at the Mortgage Bakers Association agrees that this may be the end of the road in the mortgage affordability cycle. He says, "While I don’t think they are at the point of giving out free toasters to get customers, loan creativity appears to be at maximum level."

Here at The Daily Reckoning, we can only hope that much is true.

Kate Incontrera
The Daily Reckoning

July 17, 2005

P.S. Subprime mortgages has made up more than 20% of all new mortgages in the last year. The foreclosure rate on these mortgages is nine times the rate for prime borrowers – and it will only get worse from here. If a mortgage rate moves from 4 percent to 6 percent, the monthly payment could jump up to around 30 percent.

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THIS WEEK in THE DAILY RECKONING: This week, we covered a cornucopia of ideas…from oil and energy investments, to music and memories, you can find it all below…

Good-bye, Ruby Tuesday                        07/15/05
by Bill Bonner

"Nothing stirs up memories quite as much as music – a certain song or a certain band can take you back to a different time, place or part of your life. For Bill Bonner, that band is The Rolling Stones, and the year is 1965…"

Winning the Losers Game                         07/14/05
by Dan Ferris

"Investing is a loser’s game – good investors do not pull financial rabbits out of their hats or solve difficult scientific problems. They play it safe, avoid errors in judgment – and stick to the basics. Dan Ferris explains…"

Energy’s Liquid Future                        07/13/05
by Dan Denning

"This is a golden age for oil and energy investments. Either that, or a fiery sunset that ends with oil and resource wars. But, Dan Denning prefers to look on the bright side…"

The Shopping Season                              07/12/05
by Doug Casey

"In the junior mining sector, summer is referred to as the ‘Quiet Season,’ when the flow of news dries up and brokers take off to go on vacation. However, Doug Casey shows us that this summer slump holds unrealized opportunity…"

Hairshirt Economics                            07/11/05
by The Mogambo Guru

"There is one group of people that The Mogambo despises almost as much as the Federal Reserve – journalists. And now, one has dared to challenge Mogambo’s views on Greenspan…this scrivener has no idea who he’s messing with…"

————————

FLOTSAM AND JETSAM: When the Federal Reserve meets in August, they will have some tough decisions to make. Will they continue their tightening phase? John Mauldin explores…

THE SEESAW FED
by John Mauldin

I wrote the following the first week of January:

"The Fed is going to continue to raise rates until the economy shows signs of trouble. While the Fed in the past has been willing to cause a recession, I do not think this Fed will do so. They are on the See-Saw between worrying about inflation and creating another speculative economy with interest rates too low and the concern that raising rates too much will squeeze the growth out of an economy that has grown addicted to, if not fat upon, – maybe even dependent upon – low interest rates.

"One Caveat: if long term rates do not rise, the Fed will stop sooner than 4%. They will not create an inverted yield curve on their own."

The Fed still has the same problem they had in January; only we are six months closer to the end of this tightening phase. They are almost certainly going to tighten another 25 basis points at the August meeting. The question at that point becomes whether or not they will change the language in their release, which comes at the end of the Fed meeting. Will we lose the word "measured?"

I think we need to acknowledge that the bias among Fed members, at least if I’m interpreting their speeches correctly, is to continue tightening. But it may be time for them to change their tune. Here are the main issues facing the Fed.

There are some arguments that can be made for raising rates. Clearly, the low rate environment has fostered a significant rise in the price of homes, if not a housing bubble in certain areas. The Fed, as they should be, is concerned about adding fuel to the flames. Allowing a real housing bubble to develop because of an overly stimulative Fed policy would create real problems when it burst. Significantly falling housing prices in the United States is a problem that the Fed has few, if any, tools to deal with.

When housing bubbles burst they are generally accompanied by foreclosures and thus oversupply on the housing market. Because of the large number of houses that are being bought for investment purposes with little or no money down (in some areas as much as 20% of homes are bought for investment/flipping purposes), a cycle of foreclosure would be difficult to stop with interest-rate cuts alone.

I continue to refer to a speech Greenspan gave two years ago. He said the Fed should set its policy so as to insure that significant damage is not done to the economy. Rather than try to micromanage every little part of the economy, it was better to worry about the biggest risks that would cause the most damage and use policy to avoid those risks. "First, do no harm."

If the principle is "first, do no harm" then you could also make a strong case that the Fed should stop raising rates after the August meeting.

First, it is not altogether clear that raising short-term rates will have any real effect on long-term rates, and thus on mortgage rates. It certainly hasn’t had much of an effect so far. As I noted last January, I don’t think the Fed wants to create an inverted yield curve by purposely raising short-term rates above the 10-year note.

And there are questions about the real strength of the economy. Unemployment may not be as good as it sounds. The current low U.S. unemployment rate probably understates the true level of joblessness by 1 to 3 percentage points, says Katharine Bradbury, the senior economist at the Boston Federal Reserve. Millions of potential workers who dropped out of the labor force during the recession four years ago have not returned as expected and are thus not counted in the official unemployment statistics.

Inflation is low, which is a good thing, unless you have a recession. Core inflation is below 2%. If you look at the personal consumption price index, core inflation is only 1.5% and that is the index the Fed generally prefers to look at.

There are many observers who think the economy will soften in the latter half of this year. I agree. But please note that soften is not a recession. But raising rates while the economy is in the process of softening can help bring about a recession. And a recession today (or an economy only growing 1-2%) with inflation so low would almost certainly bring back the deflationary scares of 2002. The 10-year note could drop to 3% and mortgages would go to 4%. What such a scenario would mean is open for debate, because I can argue at least three scenarios forcefully, and another 2-3 that might be of interest. It would create a lot of uncertainty. Markets HATE uncertainty.

There are other suggestions that the economy is softening. The ISM manufacturing index is in a downtrend that is worrisome. The May new job numbers came in much lower than expected, with many of the new jobs in low-end services and a guesstimate as to new businesses formed, which was the bulk of the new jobs. Making Fed policy on bureaucratic guesstimates is not the best course. The index of leading economic indicators from the Conference Board has been dropping and is suggesting the economy will slow in the next 2-4 quarters.

Oil and energy prices are beginning to have an effect upon consumer spending and are certainly a drag on growth.

On one side of the seesaw is the potential for the housing market to do well and truly overheat. On the other side is the potential to tighten too much in the face of a softening economy and maybe push the economy into recession. That would also not be good for housing and would certainly bring us closer than we would like to outright recession.

I think the prudent thing to do would be for the Fed to signal they are going to pause in their rate hike drive for a meeting or two while they keep a sharp eye on the economy to make sure things don’t get too hot. They don’t want to signal that all chances of more rate hikes are over, as that would create a new set of problems, and neither do they want to suggest they are concerned about economic growth. The press release after the next board meeting in August may be the most important we have read in many years.

What I think they will do is look at the economic numbers, and especially the jobs reports, to see how the economy is doing. If we get strong reports, look for them to tighten more. If we see signs of weakness, look for them to pause.