Spreading just like the flu
Homeboy, don't let it catch you
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
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
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
With the Fed's first rate cuts in September 2007, this was its
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.