Greg’s Note: Dan Amoss is here with another chilling tale from the Fed. The subprime mortgage villain is back, and he’s brought borrowed liquidity with him. These two working together could threaten to bring the entire banking system to its knees. Something has to be done, and only one man can do it. Enjoy the read, and send your comments to your managing editor here, same Fed time, same Fed channel: firstname.lastname@example.org
Whiskey & Gunpowder
October 18, 2007
By Dan Amoss, CFA
York, Pennsylvania, U.S.A.
Like a scene out of a Hollywood blockbuster, picture Fed chairman Ben Bernanke hovered over two giant red buttons. With sweat pouring from his brow and a giant clock ticking away, our hero must make a decision with the fate of the entire world holding in the balance. He could save the housing market while giving way to rising inflation, or try to curb inflation, letting the housing market plummet to its untimely death. What will he do?
Certain areas of the credit market are frozen, and until they thaw, the global stock markets are rediscovering their volatility. The U.S. economy is addicted to credit just as it is addicted to foreign oil. This could be the equivalent of a temporary oil market embargo.
Fortunately for U.S. debtors, help is on the way. The Federal Reserve will swoop in for the rescue by doing what it always does: promote inflation. Like a shotgun blast, the Fed will inject the type of liquidity we saw after the Sept. 11 terrorist attacks. This time, however, this blast will have a hard time making its way down the chain of lending to the credit-starved subprime mortgage market.
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The Fed’s announcement of this type of monetary policy will be cautious. Global investors have a tendency to react quickly to minuscule changes made by the Fed, but one message will ring loud and clear: Deflation is unacceptable and the Fed will fight it with every tool in its kit. It’s saying that the U.S. dollar is expendable.
Credit Inflation Raises Borrowed Liquidity
The stocks of high-quality companies exposed to energy and metals eventually will settle down, but I think we’ve still seen only the beginning of what will eventually be huge damage to the securitization market. The securitization phenomenon has allowed all debt to be packaged and sold off to investors around the world. It fueled the blowoff top in the housing market. It enabled homebuyers to purchase homes that they clearly could not afford.
Thanks to securitization, misunderstandings of the risks involved with collateralized debt obligations (CDOs), and incompetent ratings agencies, those involved in the mortgage-backed security (MBS) markets were largely ignorant of the risk they were taking. Just like the “dumb money” day traders powering the peak of the NASDAQ bubble, the complex mortgage funding setup allowed way too many bad loans to be stuffed into the MBS channel. This just inflamed the peak of the housing market.
The idea of new savings is becoming rare, and this means that all liquidity creation is borrowed. It is borrowed against rising asset prices, and once asset prices stop increasing, the liquidity evaporates.
Once this happens, selling without buyers begins, and this already hit the CDO market. As far as the housing market is concerned, inventories keep building and foreclosures keep increasing, but we haven’t seen the type of panic you may expect. People are not yet overreacting to the point at which asking prices begin to be slashed by 30-40%.
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This type of panic could develop and may happen by the middle of 2008, coinciding with the peak in ARM resets. Economists and strategists argue that since the dollar amount of ARM resets is small relative to other figures, there has been no recent panic. They have a point, but what do they think will happen to market psychology when there’s another huge spike in foreclosures and housing inventory?
The Fed Faces Difficult Choices
Recently, Bernanke considered the subprime crisis to be contained. He appears to be incorrect in the face of today’s interconnected world. Fear in one market usually spills over into several others. Bernanke also believes that a global savings glut will keep the long-term interest rates low forever, but he seems to be missing the point. As we’ve already seen, what is perceived as a savings glut is turning out to be borrowed liquidity, liquidity that can disappear into thin air.
Wall Street’s pleas for serious Fed action grow louder with each hedge fund that goes under. In August, the Fed rolled out an emergency 50 basis point cut to its discount rate. This change will stay put until the Fed decides that market liquidity has improved.
This action set off a short-covering stock market rally, but I think it’s hardly enough inflation to cover all the problems that will crop up from the massive volumes of ARM resets in the pipeline. Banks like Countrywide have had their impending short-term funding crunch eased, but they won’t be prompted to start writing a lot of mortgages again. Plentiful easy mortgages are exactly what the housing market needs to avoid another big price decline, but that’s not going to happen. At this point, foreign creditors like the Chinese play a far more important role than the Fed does when it comes to housing finance.
Bernanke is stuck between a rock and a hard place. On the one hand, he’s worried about rampaging inflation expectations, and on the other, he’s worried that a plummeting housing market could threaten the entire banking system.
I expect that he’ll promote as much creation of money and credit as he can get away with and hope that the public’s fear of inflation doesn’t return to the extremes it reached in the 1970s.
The world is safe today, but for how long?
Dan Amoss, CFA
P.S.: The thought of rising inflation leaves some sectors of the market in position to soar. In my paid newsletter, Strategic Investment, I’ll tell you where and when to invest your money in order to take advantage and profit from a slower economy. Click here to read more…
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