Embrace the Horror, Prepare for Recovery

Hard times continue to spread throughout the economy, but recent aspirations expressed by government officials could prove to be a turning point both in the economy and the markets. Unfortunately, the turn will be more akin to the moves of an 18-wheeler than a Smart car.

Last week The Wall Street Journal reported the Treasury is considering a plan to use Fannie and Freddie to drive mortgage rates down to 4.5 percent. Finally, we are getting to the crux of the problem.

Today's economic and market woes began in early 2007 as market fears of a housing bubble caused many investors to pull funds from the housing sector. The dominos fell from there driving mortgage rates up, property values down, security values into the tank and confidence into the toilet. The simple view of a resolution points to lowering mortgage interest rates, which should slow the abandonment of the housing sector, providing stability and eventually confidence.

With the Fed's first rate cuts in September 2007, this was its goal.

However, as reverberations traveled through the markets, the Treasury and the Fed became obsessed with the scalpel approach of addressing individual problems as they arose. Unfortunately, the number and size of the market disruptions masked the obvious problem of a nonfunctioning mortgage market. We were addressing the symptoms and not the cause.

Hopefully, we are now beginning to refocus on the real issue.

Historically, the Fannie Mae 30-year commitment rate hovers around 100 to 150 basis points above the 5-year Treasury bond. Considering Fannie mortgages are (as close as possible to) government-guaranteed, the yield difference is simply the cost of the call option lenders are selling to borrowers. On November 20, this measure hit an all-time high of 394 basis points, building in more than just the optionality cost - investors are simply nowhere to be found.

Assume for a moment that the market could revert to a spread of 150 basis points. With the 5-year Treasury today at 1.684 percent, that would put mortgage rates in the 3.5 - 4.0 percent range. The housing markets would then stabilize (dare we say prices could increase?) and consumer confidence would return from its abysmal levels translating to stronger investor confidence and stabilizing markets. The vicious cycle would convert to a virtuous cycle. This would be a neat trick, to say the least.

The challenge we face is simply getting mortgage rates down to the 4.0 - 4.5 percent range. Buying up mortgages is certainly a good step, but the quantity would have to be far in excess of the $700 billion mentioned in the original TARP. In addition, the ailments of the mortgage process itself need to be addressed and we must guard against the excesses experienced in the last housing boom.

The first step in moving toward a functioning mortgage market is determining what to do with the carcass of Fannie and Freddie. This drama will play out on C-SPAN over the next several months, with no real resolution yet in sight. Fannie and Freddie are such huge players in mortgages and as a result not much recovery can be expected in the mortgage process until Congress has fully determined the new structure for these two behemoths.

The horror we face in the markets today is here to stay for a while. The best course is to accept it as reality and simply as another input into your decision making process. No longer should we feel shocked at negative 600 point prints on the Dow or even the next corporate bailout à la Citigroup.

Instead, focus on survival and prepare to take advantage of the coming recovery.

Key Developments

The ISM manufacturing measure for November dropped to 36.2 and remained below 40 for the second consecutive month. The last time this index stabilized at these levels was 1982 when manufacturing was a much more important component of the U.S. economy. Nonetheless, there were no indications within the data release to suggest a recovery any time soon.

The nonmanufacturing version of the ISM data was equally depressing at 37.3 in November down from 44.4 in October. In addition, the new orders, employment, and business activity components of this release all reached new lows.

November's employment report was disappointing even to the most pessimistic prognosticators. Of the 73 economists surveyed by Bloomberg, the lowest estimate was for 470,000 lost jobs, but the figure came in at 533,000. In addition, an additional 199,000 lost jobs were reported in prior month revisions bringing the total jobs lost thus far in the downturn to 1.9 million. In the 2000/2001 downturn, the economy lost a total of 2.3 million jobs, a figure that today's recession will soon leave in the rear view mirror.