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June 20, 2008
Mortgage rates have improved, down to 6.50%, as credit-market psychology has entered a substantial reversal.
In the mass psychosis of late May, the financial markets suddenly decided that the economy had passed bottom, the banking system was recovering, inflation had become the dominant risk, the Fed would therefore begin an extended rate-raising campaign, and it was a good idea to dump every IOU within reach. That hallucination is now responding to medication.
Nothing like hard news to clear the mind: mortgage applications collapsed 8.8% in a week under the weight of spiking rates. Industrial capacity in use fell again in May, now 79.4%, overall production sliding .2% versus expected gain.
The stock market has had a very hard time since Citi’s CFO announced on Thursday that “substantial” writedowns lie ahead. Even technology stocks have cracked. The whole banking complex let go, regionals, too: very good banks, like Zions, down 60% in a year; imprudent ones, like Fifth Third, down 78%, National City down 86%.
Two crucial concepts are in play: first, the reality of the inflation fight, and second, the capital exhaustion in the banking system.
Inflation can be stopped only by economic slowdown. The combination of credit crunch and energy prices are accomplishing that slowdown here for the Fed. Effects are delayed in Asia but inevitable, social/political stability issues right behind. For the technically inclined, Paul McCulley’s posting yesterday at www.pimco.com is superb.
Captial exhaustion is hard to explain. Civilians are confused about the difference between capital and liquidity (plenty), and the Fed’s immense loans to the system (plenty, canceling a wholesale run, but no other help).
Capital is at-risk money, net worth, like the equity in your home. The authorities demand that banks raise capital, but the system has lost more in the last year than it has raised. Every time an outfit raises capital, it sells a piece of itself to new owners, “diluting” the existing ones. Capital is always scarce, but now becoming unobtainable: providers do not wish to be diluted themselves in the next round, nor wiped out by new losses. That dilution black-hole spiral is the reason for bank-stock collapse.
The heart of the matter is the mass of “structured” debt, a couple of trillion-worth, today just as indigestible and unsalable as last August, stuck in the belly of the system. So long as stuck there, the system is vulnerable to further write-downs, and there is no room on system balance sheets to extend new credit, and a continuous effort to sell anything that can be sold, good mortgages topping the list.. “No room” means that anyone wanting credit must pay up. Way up.
The best evidence of capital exhaustion lies in the strangest set of mortgage prices in anyone’s memory. The fixed-rate Jumbo market has been broken since August, above 8% now, and only a thin appetite for Jumbo ARMs. Super-sized Fannies and FHAs now have reasonable rates, but are available in only a handful of metro areas.
Fixed-rate conforming loans still trade almost one percent above historical spread to Treasurys, far in excess of credit risk. However, the exclamation point signal of a broken system is the Anti-Teaser ARM. Since rollout in 1980, anybody who would take a 5-year ARM and shield the lender from future interest-rate risk got an artificially low rate for the first five years, below the “fully-indexed” rate.
Index value (1-year T-bill = 2.50%) plus margin (2.75%) equals fully-indexed 5.25% today. Depending on some variables, yield curve and all, the initial five years should have a teaser close to 4.50% without little or no “origination” fee. Today’s quotes are over 6.00%! Anti-Teaser. Offer to protect a lender from rate risk, credit guaranteed by government agency, and for your trouble you get the ol’ waterboard.
Next time you run into one of the “worst-is-over” boys, ask him to explain.
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