Just in time for Christmas, the
Fed gave us a quarter point interest rate cut, even though
everyone was hoping for a bit more in their Christmas stocking.
The turmoil in the mortgage market has apparently refocused
the Fed from inflation fears to recession fears. Everyone
knows that our economy cannot continue to grow at the 4.9%
annual rate it exhibited in the third quarter of this year.
The consensus points to about 1.8% in the fourth quarter and
possibly slower into 2008. As we have stated in past letters,
it is not high interest rates or a lack of money that is creating
a “credit crunch.” It‘s more a lack of lenders
willing to lend and of borrowers willing to borrow because
of the uncertainties in the economy brought on primarily by
the massive write downs of delinquent mortgages by financial
institutions.
The Fed hopes to send a message to investors that it stands
ready to do what they can to get us through this financial
crisis. Financial panics are nothing new. We have been through
them ever since money was invented, and we will get through
this one too (and, no, Al Gore did not invent money).
The Fed Funds rate is a target rate set by the Federal Reserve.
Banks are naturally required to hold a certain amount of dollar
reserves against the amount they lend out. If a bank falls
below its reserve requirement, they can borrow from another
bank that has a surplus. The interest rate one pays is negotiated,
and the weighted average of the rate across all banks is the
effective Fed Funds rate. By reducing the target rate the
Fed can stimulate more lending to promote the economy. Another
means the Fed can use to stimulate the economy is through
the discount rate. That is a rate the Fed will charge banks
for taking a direct loan from the Fed at the “discount
window.” The current Fed Funds rate is 4.50% and the
discount rate is 5.0%. The Fed may decide to cut both rates
on December 11 and also extend the available maturities on
these loans. A third way to stimulate the economy would be
for the Fed to cut reserve requirements for banks. Bottom
line is that the Fed has some weapons to use to forestall
a recession and is letting investors know they stand ready
to use them.
So, just how dire is the mortgage market? First of all,
the value of US home mortgages as of 3-31-07 was $10 trillion.
This is an extremely important part of the economy, and the
country in general. The dream for most people is to own a
home and it is usually the most valuable asset they will own
and the last asset they want to relinquish. So rest assured
that the Fed and the government (both federal and state) will
do everything possible to insure the stability of this market.
In a recent interview, Daniel Mudd, President and CEO of Fannie
Mae, said that there are $600 billion to $800 billion of sub-prime
mortgages in the US, and that $185 billion of those mortgages
will have some kind of interest rate reset next year (mostly
higher). Many homeowners will not be able to meet a higher
mortgage payment and will default. Who is at fault? Virtually
everyone.
Unscrupulous lenders put people in no-down payment, no interest
or teaser loans they knew would default. People that desperately
wanted a house probably knew they would have trouble making
payments down the road. The Fed promoted this with extremely
low interest rates, and then you had people flipping houses
for a quick profit. All added up to a recipe for disaster.
So what is the solution? There are several ideas being discussed
such as:
1. The consumer takes the hit, loses home and starts over.
2. State or federal government adds money to the market.
3. Lending institutions re-work mortgage payments.
4. Try to help only those who can pay and forget those with
no chance to pay and those flipping house.
The solution will probably be a combination of these factors.
Finally, what about investments in agency pools of adjustable
rate mortgages?
First of all, GNMA is a government agency and Fannie Mae and
Freddie Mac are government sponsored entities (GSEs). Second,
they are well capitalized and use primarily private financing
for their cash needs (preferred stocks, common stocks and
bonds). According to Mr. Mudd, Fannie Mae has never taken
a penny in aid from the Federal government. Third, the agencies
exposure to sub-prime loans is minimal. Again according to
Mr. Mudd, Fannie has less than 2% exposure to this market,
and they have put a heavy emphasis on restructuring those
loans.
One last note on solutions. We need to keep the Bush administrations
tax cuts in place. Raising taxes, both corporate and personal,
would only cause more defaults in both areas.
Here we are approaching the end of another calendar year.
Maybe it’s just age, but every year seems to bring more
changes and crises. But what a great country we live in. The
human spirit in this country is phenomenal and is the main
force available to resolve these crises and move forward.
May this human spirit touch all of you in some way as we enter
the New Year.
Random thought for December 2007:
A global warming thought for the holidays - In orbiting
the sun, the earth departs from a straight line by one-ninth
of an inch every 18 miles – a very straight line in
human terms. If the orbit changed by one tenth of an inch
every 18 miles, our orbit would be vastly larger and we would
all freeze to death. One-eighth of an inch? We would all be
incinerated!
- Science Digest, February 1995
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