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
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
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
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
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
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