The Fed’s Role in All of This – Lender of Last Resort

On Noah’s post last week about the Fed’s $30 billion bailout of Bear Stearns, one reader commented that the Fed was using taxpayer money to bail out the company.

It’s a valid thought; after all, why should the government – at the expense of taxpayers - have to pick up the tab to rescue some bank that got us into this rut as a result of the bad judgment of a bunch of rich guys? And meanwhile people are losing their homes and their jobs.

Much is being said about WHAT the Fed does, but not on HOW it does it. So what I’d like to do here is explain on a high level how the Fed operates and the impact on the US taxpayers. The reality is that it's less than people think.

For starters, when the Fed loans to a bank it requires the bank to back it up with collateral of at least 100% of the value of the loan. The collateral must meet certain liquidity guidelines and the amount depends on the collateral type (i.e. Treasury bills might only require 2% above the loan amount vs. AAA corporate bonds that might require 5%). This way if the bank defaults on the loan, the Fed is covered. Today’s Wall St. Journal includes a good article on how this works; subscription only though.

But if the collateral is gone? Well, then the Fed must run to Congress to fund at the taxpayer’s expense; but the likelihood of this would be remote.

So how does the Fed fund itself; for a primer click here for the structure of the Federal Reserve? Each Federal Reserve District Bank (there are 12 of them, plus the Board of Governors in DC) earns its own income from a spread through issuing Treasury securities and other activities it provides to banks in its respective district, i.e. money transfer services such as Fedwire. Because each Fed Bank is not allowed to operate for a profit, it must return all revenues in excess of operating expense to the US Treasury. So therefore you could argue that this is an indirect cost to the US taxpayers…though on the other hand it wouldn’t be spending anything it’s not earning in the first place.

Although the Fed has government oversight, it runs independently. This is done on purpose in order to ensure its actions are in the best interests of the economy and not politicians in Congress….and one of the reasons why the US is still considered to have the most solid financial system in the world.

So what does the Bear Stearns bailout mean for US taxpayers?

The loan that the Fed is extending to Bear - actually to JPM Chase for Bear - is secured by collateral, as noted above. If the collateral runs out the Fed must obtain funding from either borrowed funds (Treasury bonds) or – yes, you guessed it – US taxpayers. But the latter would be in dire circumstances and unlikely to happen.

Enough of the Fed…the real risk to taxpayers is new regulations permitting Fannie Mae & Freddie Mac to reduce their required capital reserves, allowing them to expand their mortgage portfolios. This actually places US taxpayers at GREATER risk than the Fed’s recent action, but doesn’t get as much notice. But that is another post for another day….

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Fed Set To Cut; Will They Save Their Bullets?

A: We are about an hour and a half from the fed's next rate cut. The question is not whether they will cut, but by how much. This horse agrees 100% with BR over at The Big Picture, which shouldn't be a surprise to anyone here, that they need to exercise restraint and cut only by 1/2 point; limiting the negative effects on the US dollar & commodity prices while acting nonetheless. By saving their bullets now, they will have more ammo to use as the economy weakens, housing continues to be a drag, and credit markets correct themselves.

Unfortunately, I do not think 1/2 point will be the move. I think they will cut 75 or 100 bps this afternoon as a 'shock & awe' offensive to limit the severity of the slowdown and give the markets what they want. I must admit in hindsight, Ben & company handled the Bear bailout wonderfully as they orchestrated an orderly liquidation and averted a complete financial meltdown. Putting my feelings aside of letting the free markets punish those that are weak and the vultures jumping in to grab whats left, the fed's actions avoided chaos that could have played out as a domino effect of Bear Stearns announcing bankruptcy. The move to bail out BSC does NOT fix the housing problem, it does not fix the expectation for rising unemployment & inflation, and it does not fix the expectation of weakening economic data resulting from the credit storm; hence the rate cut move that will come today.

On February 29th I published a post titled, "Credit Check: Running Out Of Bullets", where I stated:

"With future rate cuts likely resulting in further commodity inflation, I'm concerned that we are going to be running out of bullets soon and will have to deal with a period of financial stress without the fed's strongest weapon available to us."

That was over two weeks ago. Two days ago, Bloomberg published their version of what I was discussing in their article, "Bernanke May Run Low on 'Ammunition' for Loans, Rates":

Federal Reserve Chairman Ben S. Bernanke may be running out of room to pump money into the financial markets and cut interest rates to rescue the economy.

The Fed has committed as much as 60 percent of the $709 billion in Treasury securities on its balance sheet to providing liquidity and opened the door to more with yesterday's decision to become a lender of last resort for the biggest Wall Street dealers. The central bank has cut short-term rates by 2.25 percentage points since September and will probably reduce them again tomorrow.

"They're using up their ammunition on the liquidity and overnight interest-rate fronts," said Lou Crandall, chief economist at Jersey City, New Jersey-based Wrightson ICAP LLC, a unit of ICAP Plc, the world's largest broker for banks and other financial institutions.

Barry Ritholtz discussed today on CNBC his feelings on the issue and is in the same camp that I consider myself a part of:

"I believe that the FOMC should "man up," show some backbone -- cut rates by "only" 50 bps. They might find out what its like not to be at the Market's beck and call (girl). That should stabilize the greenback, and perhaps send food and energy prices lower (earning Ben the appreciation of consumers through out the country)."

But I do not think it will play out this way; time will tell. In meantime, I urge you to maintain a clear head as you interpret the events that result from this credit storm. Bear market rallies are always sharp and filled with glimmers of hope; I believe this rally to be no different. Time will heal what ails us and it's clear the fed will take every step necessary to limit the severity of the recession and the pains of the de-leveraging process. Yesterday a bear was shot & killed but not before many innocent employees got their retirement plans wiped out. Whats next?

The unknown continues to be:

a) who holds what toxic assets
b) who is experiencing a liquidity crisis similar to Bear
c) when will foreclosures / defaults reverse course
d) when will credit markets normalize; credit spreads continue to narrow
e) effect on global markets
f) pipeline inflation
g) spread to higher quality / other debt classes
h) severity of job losses to come
i) severity of economic weakness
j) effect on local state budgets
k) spread to other markets (ars, muni's, etc)
l) effect on main street

Steps are being taken, but we are not out of the woods. This is not a daily fix, it is a quarterly to yearly fix rooted by housing that will take time to play out! We went from years of credit fueled leveraged bets to a complete STOP in a matter of months; we have been at this STANDSTILL since mid-to-late 2007 and we are yet to see the economic effects of this. The good news is, we must go through this to get out of it, so in my opinion and as I said over 6 months ago, BRING ON THE RECESSION!

PHOTO: Source

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Fed Cuts, Market Loses Gains, Ratings Downgrades Coming

A: I think reality is setting in that there is a reason the fed is acting so aggressively; risks to the economy. The drug injections Ben handed out today obviously wasn't his best stuff and the addicts on wall street feel shafted. In the meantime, reality wakes us up. Fitch cut the rating on FGIC, the 4th largest bond insurer and S & P lowered, or may lower ratings on up to a half a trillion, thats trillion with a 'T', of subprime mortgage securities and CDO's.

It brings me no pleasure to say that reality beat out a drug induced fantasy today on wall street. The fed used more of its precious ammo and cut both the FFR & Discount window by 50 bps, yet markets sold off by the end of the day due to the realization that there are valid reasons why the fed is acting so aggressively. Meanwhile, expect commodities to rise and inflation pressures to rise in the years to come as the fed clearly is pulling out everything in its arsenal to combat the problems bubbling under the surface. Sooner or later, a billion dollar write down starts to mean something.

Since the rate cut is not news anymore, lets get to what spooked the markets. According to Bloomberg (via Calculated Risk):

Standard & Poor's said it cut or may reduce ratings of $534 billion of subprime-mortgage securities and collateralized debt obligations as default rates rise.

The downgrades may extend losses at the world's banks to more than $265 billion, S&P said.

Then came Charlie Gasparino and his gut instinct of bond insurer downgrades coming as early as today; recall posts on UrbanDigs here & here and here about this possibility and likely effects. Then it happened. According to Bloomberg (again, via Calculated Risk):

Financial Guaranty Insurance Co., the world's fourth-largest bond insurer, lost its AAA credit rating at Fitch Ratings after missing a deadline to raise capital.

Financial Guaranty, a unit of New York-based FGIC Corp., was cut two levels to AA, New York-based Fitch said today in a statement. The company had been AAA since at least 1991. Moody's Investors Service and Standard & Poor's are also reevaluating their ratings.

The loss of the AAA stamp jeopardizes ratings on bonds Financial Guaranty insured and limits the company's ability to generate new business. FGIC, along with MBIA Inc. and Ambac Financial Group Inc., are paying a price for expanding beyond their traditional business of backing municipal bonds to guaranteeing debt linked to riskier subprime mortgages and home- equity loans, as well as collateralized debt obligations.

As bond insurer's get downgraded, further write-downs in the financial sector becomes a reality. Again, we just don't know who holds what, whats insured, for how much, will the claims be paid, and on and on. Its all interconnected and being fueled by a slumping housing market, rising defaults, and a dysfunctional secondary mortgage market where these securities trade.

What does this all mean? A few things come to my mind:

a) The fed is on our side. While we have pain to go through until the ship is righted, when the clouds clear there will be another fed assisted economic boom. The question is when. This will certainly help, but I'm afraid it will take some time.

b) I love gold.

c) The fire is fueled by deflation in housing prices across the country. As home values fall, so does equity withdrawal strapping the homeowner. Those holding homes whose loan balance now exceeds the value of the asset, are considering walking away from their homes. Those who cant afford to pay their mortgages, simply aren't. Its becoming socially acceptable to go into foreclosure these days as that may be the best financial option for the struggling homeowner. And guess who lent out the money, bundled it into a security, and sold off the bond to investors who are now holding the toxic waste?

d) As defaults rise, holders of the securities derived from these debts lose. Hence the billions of losses you are hearing about. So far, we've seen the lowest quality homeowners get hit; naturally. Risks to other debt classes?

e) Leverage. The unsustainable housing boom built from lax lending standards, rising home prices, speculative investing, and low low rates was leveraged up the wazoo! That makes the problem that much more complex and is clear by the struggling financials and those who bought up the risk globally. We will have to fix the financials before we can get through the downturn. Its clear the fed knows this and is taking aggressive action! It will help, but it will take time.

f) Over-estimating Losses? A very valid hope! It is entirely possible that if all this stimulus helps to stabilize housing as time goes on, that losses are overestimate. Way too early to tell now, but certainly a valid hope that I am clinging to and watching out for. I am NOT in this camp right now.

We will get through this. But we are talking about a housing/debt fueled problem, so it will take time. Housing is an illiquid asset, as opposed to stocks, and take time to sell on the open market. With inventory outside Manhattan a concern, it will take time to work through this process. All eyes should be on housing data for signs of:

1) decreasing iventory
2) rising sales volume
3) decreasing absorption rates

...for any clue as to when the clouds may clear.

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Pipeline Inflation: Here Already?

A: When the fed announced its actions on Tuesday, some were wondering why the previous bias towards focusing on growth suddenly seemed to disappear. In its place, was more wording about inflation. I've discussed pipeline inflation plenty here on urbandigs.com over the course of the year, and it's clear that with today's economic data it will begin to take headlines once again. Think to yourself sarcastically, ..."you mean, record high energy prices, higher commodity prices, and higher food prices are inflationary?". Yes, they are.

Forget the whole argument about headline vs core for a moment (read my recent post, "Fake OR Real Inflation?", back in mid November - Search Results for ALL "inflation" articles), today's CPI data came in hotter than expected all around. According to Yahoo Finance:

The Labor Department said the consumer price index rose 0.8 percent in November amid a spike in gasoline prices. The 0.8 percent increase in consumer prices topped the 0.6 percent rise economists had been expecting. The report also showed core inflation, which excludes often-volatile food and energy prices, rose 0.3 percent, the biggest increase in 10 months. The report also found large increases in the cost of clothing, airline tickets and prescription drugs.

The report raises questions about the Fed's plans for priming the economy.

This is important because it will change the roadmap of policy actions by our fed. It will also bring treasury yields up & strengthen the US dollar; all part of the system correcting itself and certain markets reverting back to the mean (treasury's & currency's). If the fed either doesn't ease as much or is forced to consider rate hikes sooner rather than later, it will strengthen US dollars. Think of how many traders are short US dollars and will ultimately need to cover those positions!

Barry Ritholtz over at The Big Picture provides this chart on the year-over-year changes of the CPI Headline & Core #'s showing the sharp uptick since July:

The 0.8% gain was the largest since Hurricane Katrina's boosted CPI in September 2005. That was obviously a weather induced number, and you need to go all the back to January 1990 to find a comparable CPI price increase. And the so-called Core? 0.3% gain was the most since June 2001.

So, what do these inflation figures really mean?

Well, you can forget about a half point cut anytime soon -- at least until the Fed has gone from nervous to scared $#@tless. That's how you know they are in full blown panic mode.

Pipeline inflation (as I like to call it), the buildup of inflation from the past 6-12 months that is yet to trickle down into higher prices for consumers and be reflected in economic reports, is very real. While we may see short term rate easing as the fed tries to stave off any slowdown from the credit crunch, we are probably in for a medium-longer term period of rate hikes. It's just that this credit crisis needs to show signs of normalization, and the housing market needs to stabilize before the fed can risk raising rates; so we have some time and maybe even another rate cut or two in the near term as recession fears remain.

As for lending rates, I would expect them to tick higher on this report. However, you must keep in mind that these days there is less and less relation of fed action and bond yields on lending rates. The reason is the credit crunch, the risk that comes with mortgage lending, and the risk aversion of the banks to this type of lending. Add that all together and you get:

a) higher cost of debt
b) tighter underwriting
c) fewer loan options

...so yes, the credit crunch is related to real estate on a macro level. The time it takes to hit local markets will lag. My thoughts on our fed? I think they will still act in the near term (lower rates) as the credit crunch lingers, but that longer term we will see the lagging effects of global inflation leading to a more sustained campaign of rate hikes in the years to come.

Related:

Inflation in the Euro Zone Climbs (AP)

Inflation in the 13 nations that use the euro surged to 3.1 percent in November versus a year earlier, its highest level in more than six years, the European Union's statistics agency Eurostat said Friday. It is now well over a guideline of just under 2 percent that the European Central Bank looks to when it decides whether to raise interest rates to boost borrowing costs.

But the ECB is now under pressure to keep rates on hold to encourage reluctant banks to keep lending out money to each other in the wake of a credit crisis where they are worried about taking on extra debt.

Inflation: Hot & Getting Hotter (BusinessWeek)

A larger than expected pop in the November consumer price index may temper the Fed's willingness to loosen policy any further. As if the Federal Reserve didn't have enough headaches these days, inflation appears to be on the march after a long period of relative quiet. Case in point: The release of the U.S. consumer price index for November on Dec. 14. The headline CPI surged 0.8% on the month, while the core rate, which excludes food and fuel, rose 0.3%. Markets expected tamer rates of 0.6% and 0.2%, respectively, according to S&P MarketScope.

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Fed Time Again: 25 or 50 Bsp?

A: It's the day before the next decision on fed funds rates. Everyone gather round and huddle up. What should be done?

Arguments For 1/4 Point Rate Cut: The more likely option. Since Fed vice chairman Donald Kohn spoke a few weeks ago, the equity markets have translated his words (backed by a Bernanke speech the next day) into a rate cut induced party burning the shorts and resulting in a nice recovery after a very dangerous selloff. Now that wall street has undoubtedly 'priced in' a 1/4 point rate cut, the question is will there be any surprises?

The argument for a 1/4 point rate cut remains the same. The downside risks to the economy are clear, even though at this point in time the economic data continues to show some strength and moderating inflation; giving the fed some room to cut. Flawed or not, this is the data the fed looks at. The credit markets are still in distress, the housing market is getting worse at a faster pace, the future with ARM resets is cloudy at best (even with this gov't sponsored private sector rate freeze plan), and even Stevie Wonder can see the red flags waving that could hurt the consumer and the US economy in the months to come.

As a result, the fed will cut at least by 1/4 point to forestall the adverse effects to the economy. With pipeline inflation still a concern and the US dollar still very weak against other major currencies, the argument for a 1/4 point rate cut gets stronger. Plus, by cutting only by 1/4 point, the fed can save some ammunition for later use should things get real hairy in 2008; something that can prove to be vital to help restore some confidence without over-stimulating the economy or presenting a moral hazard for all those that made bad bets again.

Arguments For 1/2 Point Rate Cut: The main arguments for a 50 basis point rate cut is a combination of the fed being behind the curve already, the street already pricing in 1/4 point cut, and that the macro data shows a seriously slumping housing sector that will inevitably bleed into consumer spending. We know that there is a lack of liquidity in the secondary mortgage markets, but fed rate cuts do little to reverse that. We know that the credit markets are in distress, but that has to be worked out on corporate balance sheets (hey there, UBS with another $10 Billion in write downs; how are you doing?) first before normalizing.

And we also know that the housing market will get worse before it gets better and the side effects of that on the consumer, in my opinion, is the biggest argument for the fed to be aggressive and cut rates by 50 basis points.

For now, lets enjoy the free round of tequila shots that the fed has provided us via speeches by its members, as it almost makes it look like things are getting better. Beware not to confuse rate cut induced rallies for confidence & certainty returning to the marketplace. While subprime has taken all the headline blame for what is going on right now, let us NOT forget that there are plenty more loans out there that are waiting to go bad: option arms, hybrid I/O loans, cosi & cofi loans, alt-a (already starting), second mortgages, HELOC's, credit cards, and prime loans (already starting).

THIS IS NOT A SUBPRIME PROBLEM! This is a complete mortgage/lending mess that has yet to fully reveal itself and explains WHY the fed is taking aggressive proactive measures to soften the blow expected to come.

MY BET

65% ---> 1/4 point rate cut fed funds, 1/4 point rate cut discount window
30% ---> 1/2 point rate cut fed funds, 1/2 point rate cut discount window
5% ---> some combination of above
0% ---> NO CUT; that would be a shock

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Bond Yields & Mortgage Rates No Longer Related

A: I want to touch on this topic as I have been asked recently why mortgage rates are not falling as much as 10YR Bond yields have? In the past there was a much closer relationship between 10YR bond yields and lending rates, but something changed. Risk joined the party. As a result, investors deemed mortgage related security products much riskier than in the past and would only be interested if the yield that came with this riskier bet was increased. For main street, any debt that is related to the current fear of delinquency & default risk, comes with a higher borrowing cost. In this new world where risk has been re-priced, that is the key term here, bond yields are no longer a reliable indicator to the future direction of lending rates. Instead, lending rates will be more closely tied to the evolving credit crunch and will act more on credit history than ever before!

Lets see what I mean. The simplest way to get statistical evidence of what I just said, we must look at how 10YR bond yields & NY 30 YR Jumbo mortgage rates have performed over the past month or so! Lets no forget that things have changed significantly over the past 30 days as the credit crunch worsened, stocks sold off, bond yields plunged, and yet lending rates went higher. Here are my sources:

BANKRATE.COM: showing the trend of NY 30YR Fixed Jumbo mortgage rates; 1 month
MARKETWATCH.COM: showing the trend of 10YR Treasury Yield; 1 month

I merged the two line charts onto one graph that shows:

a) the downward trend of 10YR bond yields
b) the upward trend of 30 YR Fixed Jumbo rates

I don't know how much more clear this point can get! During times of credit distress, your credit rating will be more important than ever in deciding how low of a rate you can get on a loan as lenders try to clean up their books, tighten lending & underwriting standards, and assign a higher rate to riskier borrowers!

My friend and fellow blogger Dan Green will support this theory now, but argued with me a number of times in the past before the credit crunch invaded; where I often showed you charts relating the 10YR bond yields to mortgage rates.

Dan discussed recently, "Where Mortgage Rates Come From", and stated:

Mortgage rates are "made" from the price of mortgage bonds using a mathematical bond formula. This is fact. And by exclusion, this also means that mortgage rates do not come from the price of the 10-year treasury note.

So, let's hammer the point home. As of 2:00 P.M. ET yesterday (Nov. 20th), the U.S. treasury market was rallying. The bond market looked good from 30,000 feet. A check into the mortgage bond market, though, showed that mortgage prices were getting killed, off 25 basis points.
This is about the same time that my inbox starting dinging with new mortgage rate sheets reflecting higher rates from our nation's lenders. I wasn't surprised by the reprice for the worse because I had been watching the market slowly slip away on my MBS ticker all day. I had ample time to contact a few clients and get them locked in at lower rates before the reprice.

So, at least there is one agreeable point here: 10 YR TREASURY YIELDS ARE NO LONGER RELATED TO LENDING RATES; ESPECIALLY JUMBO RATES! At least Dan provides an actual answer to where rates are linked to, the fixed rate mortgage backed securities (via The Mortgage Market Guide). Does your loan officer have this tool for real-time reporting? I'd certainly be surprised if they did.

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Expect Surprise Fed Rate Cut

A: I'm going with my gut on this one. I think the credit crunch has matured to the point where we could see Ben Bernanke & Co., surprise with an inter-meeting cut. I know, I know, this goes against everything I said only a week ago when I didn't want the fed to cut. Fact is, I don't! We have enough problems with pipeline inflation, weak dollar, and rising commodity and energy prices. But there is a big difference between what I want, and what will happen. I think the credit crunch is getting so bad, that it wouldn't shock me to see the fed use the element of surprise before years end to try and restore some confidence via a stimulative inter-meeting rate cut.

The problem is the rate cut will not be a cure, it will only dampen the effect that the credit crunch has on the overall economy in the months to come.

Here are my concerns:

a) Nov. 15th accounting change; level 3 assets set stage for more widespread write downs
b) Citigroup & Merrill announce pain & management shakeup
c) Mortgage insurers whacked; should insurance availability for CDO's & CMO's shrink or outright disappear, or claims can't get paid out, we'll have major problems for those holding these bad assets
d) Ratings agency downgrades will lead to more credit pain
e) Nationwide housing slump continues; foreclosures & delinquencies rise predicted by ABX Indices

Again, I think the best way to get out of this mess is for our economy to go through a nasty recession that penalizes those that made these bets, without aggressive easing by our fed that may cause a moral hazard, weaken our dollar further, and buildup pipeline inflation. The recession itself will flush out the problems, clean off the balance sheets, and help ease inflation pressures. But, I doubt the fed will stand idle and let this scenario play out like that. They will most likely take action and cut rates to limit the severity of any recession, at the expense of:

a) bail outs; creating a moral hazard
b) weakening our US dollars further
c) rising energy prices
d) rising commodity prices
e) pipeline inflation

Thoughts?

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To Mr. Bernanke: BE STRONG!

A: The fed meets and decides the next move in the fed funds target rate on Wednesday. We also get plenty of economic data this week, which I'm sure the fed will get early access to before making their final decision on rates! The biggest reports will be GDP on Wednesday, ISM Manufacturing Index on Thursday, and the Employment Situation report on Friday. With the fed funds target rate at 4.75%, I wonder, is that really restrictive to economic growth? While the US dollar tanks, oil surges to $93/barrel, stocks just off record highs, and other commodities trek higher, it's hard to imagine that Big Ben will be aggressive with rates on Wednesday. But we all know he will because thats what the market wants! I say, be strong Ben! Show us you own a set of cahones, support our dollars, tell the markets you are not their bitch, and surprise us with your inner strength!!

Free market capitalism, HA! What a joke! It's clear that Ben Bernanke and the fed is a printing press for the tradable markets and will do everything in their power to keep the game going a bit longer and help bail out all those that made bad bets. Only it won't come out like that. It will come out as if the fed is acting to, "...forestall adverse effects to the US economy", or some similar jargon. Meanwhile, expect your dollars to be worth less soon.

With that said, there are problems here. The problems are a direct result of bad bets and bad loans that never should be made in the first place. So, to fix the problem the fed is pumping liquidity into the financial system, at the expense of our US dollars' value and future inflation in the pipeline. Companies are trying to team up and get this super conduit called MLEC up and running so that those holding bad assets can get bailed out and don't have to be forced to sell at distressed levels. Gone are the days where bad bets are penalized by the tradable markets, because if they were it would cause financial distress to our economic system that maintains afloat from interventions from government and private institutions. That is why free market capitalism is NOT AT WORK HERE!

If it was, the markets would have to work themselves out and stocks of banks, lenders, and others who hold these assets would have corrected significantly more; and that is obviously not happening. We have become a society that fears recessions rather than understand them for what they are; healthy and normal disruptions in economic growth necessary to ensure longer term sustainable growth. We need to shake out the bad bets and weak players, let the markets fix themselves, and move on with the lesson learned.

The US economy is slowing and jobs growth is decelerating, no doubt about it, but what happens if the US dollar continues this freefall? What happens to our immediate future if oil prices jump to $120/barrel; which will occur if the fed maintains an easing policy? Won't that hurt us even more down the road? Do we really need to keep cutting rates BEFORE the economic data clearly shows that they are needed at this stage of the game? Is 4.75% fed funds rate really that restrictive?

I think Ben Bernanke needs to stand tall, tell wall street he is NOT THEIR BITCH, and NOT CUT TARGET RATE AT ALL! Instead, I think they should leave the door open for more cuts if need be, and they should cut the discount window so that it comes down to where the fed funds target rate is now at 4.75%! If they do cut, at most cut rates 1/4 point and be clear in their message that future rate cuts are not a certainty!

Right now, banks are announcing major losses in write downs and wall street is treating those acknowledgments fairly positively. I mean, UBS comes out today, warns of losses that will extend to future quarters filling the air with uncertainty, and the stock is down all but 0.71%! Are you kidding me! The reason why the free markets are not working properly right now is because they are waiting to know how many shots of heroin their pimp is going to give them!

Here are facts:

- Stocks are 1.5% or so from Record Highs
- Oil is at Record Highs
- Problems lie in credit markets; cutting rates will NOT cure this problem
- Rate cuts will help cushion any slowdown that may come down the road

I would LOVE to see the fed do NO CHANGE with rates on Wednesday, but I doubt that will happen. The credit markets are still in distress, there are more losses yet to be reported, we still do no know who holds what, and if the fed does nothing the markets will selloff and correct. Awww, cry me a river. I wonder if Big Ben can handle a little selloff on wall street?

Am I alone here in this way of thinking? The fed funds futures are actually starting to predict a slight chance of ZERO CUT at the meeting. Bill Pimco says we need a fed funds rate of 3.75%; might as well burn our dollars for heat! Here are some other thoughts around the blogoshpere:

Fed Calls: Quarter-Point Consensus (Real Time Economics - WSJ Blog)

Wall St Wants 50, Fed May Give Zip For Now (Bloomberg)

No Free Lunch: Ongoing Ramifications of an Easy Fed (The Big Picture)

The Fed's Dilemma (Econoday - Simply Economics)

Fed Meeting Wednesday Keeps Pressure on US $ (FXView)

Countdown to the Fed (Think BIG: Bespoke Investment Group)

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Expect Another Preventative Rate Cut

A: Stocks are just off record highs, fed funds target rate is at non-restrictive 4.75%, the US dollar is at record lows and sinking further, oil is bubbling at record highs, inflation is a long term threat, and commodities are at very high levels; hardly an environment that needs rate cuts. But this credit situation is much worse than many people think and I think the fed is cutting rates now so that when they 'kick in' in the future it will be just when we need them to! It's a very confusing time right now, leaving me to focus on the biggest threat to everything: the credit markets.

The fed has two decision meetings left for this year; Oct. 31st & Dec. 11th. As much as I don't want it to happen given inflation concerns down the road, it looks like the fed will cut rates again by 1/4 point at the end of this month.

The earnings for major banks have come out in the past few weeks and they have been nothing short of disgusting!

* Wachovia (WB) - Wachovia Corp. before Friday's opening bell said its third-quarter earnings fell 10% from a year earlier as the bank booked a $1.3 billion write-down as a result of disruption in fixed-income markets.

* Bank of America (BAC) - Nose-diving profits at the company's global corporate and investment-banking group were behind the earnings miss. Profits at the unit fell 93.0%, to $100 million, from $1.43 billion a year ago.

* Citigroup (C) - Citigroup, the global banking giant, said today that third-quarter profit dropped 57 percent after it faced heavy blows to its fixed-income and consumer businesses. "There really is a lot of deterioration happening in mortgages right now," Gary L. Crittenden, Citigroup's chief financial officer, told investors and analysts on a conference call today.

* Washington Mutual (WM) - Washington Mutual Inc. shares fell nearly 8 percent Thursday, a day after reporting fallout from the housing slump drove its third-quarter profit down 72 percent. Chief Executive Kerry Killinger said "increasingly difficult market conditions" are hamstringing the banking industry.

Just to name a few of the big boys. We heard about insolvency cases at Rhinebridge CP and fire sales of assets to meet debt payment deadlines at Tango Finance, Ltd.. But the most compelling case that problems are getting real serious again in the credit markets, comes from the plunge in the ABX Indexes over the past few weeks. Folks, if you want to get an idea of investor sentiment in the subprime mortgage backed securities world, you look at the ABX Indexes! As I have discussed since Tuesday, things are getting very scary! The chart below shows you the selloff in the ABX Index for 'AA' paper. Look at that selloff since October 11th (I inserted red 'y' and 'x' axis so that you can see the low we hit when the credit mess first hit, the recovery, and the recent selloff taking us below the low point hit back in early August)! We are now lower than the bottom hit when the credit crunch first came to the surface back in early August; you know, when the Dow went from 14,100 to about a trading day low of 12,455 or so in a 2 1/2 week period + started the changes for everyone seeking a loan!

The Wall Street Journal Blog, Real-Time Economics, had a post yesterday citing a quote from a hedge fund manager who said:

...Somebody told me this morning, ‘It is starting to feel like early August, and not just because of the weather"...

This hedgie insider is referring to the dysfunction going on at the core of the credit markets; the secondary mortgage markets! The ABX Index is real evidence of this distress! On Tuesday, I thought I wrote a great post titled, "Will The Real Hangover Please Stand Up", but it didn't get the reader participation I was hoping for. In that post I stated:

It was clear that equities were drunk on rate cuts, as I posted last week, and I think the street is yet to adapt fully to a world of credit restrictions, solvency issues, global inflation and higher rates. The first credit blip was an 'awakening' of sorts, and for those that think it's completely over, well, stop hitting the snooze button! Is the latest collapse another indication of distress in the credit markets? I've mentioned before that the credit mess is NOT OVER! We are yet to see the full dragging effects of the credit turmoil in corporate earnings and the side effect to investors and the consumer.

The DOW is now down 290 points or so from when I wrote that and it's because something is brewing in the very confusing, mis-understood, world of credit! I think another round of woes is very near and it looks like the fed will have to act to limit the ultimate drag on the US economy down the road.

Expect another preventative fed rate cut to help 'forestall some of the adverse effects on the broader economy that might otherwise arise from the disruptions in financial markets and to promote moderate growth over time.'; as the fed stated with their last easing!

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Hot Numbers & The Misleading Core

A: Hot economic data folks. The headline PPI came in high at 1.1%, while excluding food and energy in the so-called core PPI came in at 0.1%. Retail sales were strong. The question in my mind is how much weight should be given to the CORE #'s overall as the fed targets inflation; Barry Ritholtz's take on the misleading core is well known. Fact is, the US economy is a mature, resilient economy and as such I think the day of the CORE # has passed. Inflation is OUT there and the fed's model of focusing only on the core needs to be updated so we don't get hit by the 'cruelest tax of all'. Lets discuss.

First the data. According to Yahoo Finance:

Retail sales posted a stronger-than-expected gain in September as a big jump in auto sales helped offset weak demand for clothing. The Commerce Department reported Friday that retail sales increased 0.6 percent September, compared to August. That was double the gain that economists had been expecting and was also in contrast to reports Thursday of sluggish demand from the nation's leading retail chains.

In other news, the Labor Department reported that wholesale prices jumped by 1.1 percent in September, pushed higher by gains in food and energy costs. Excluding those volatile categories, wholesale prices were up by a moderate 0.1 percent.

The street interprets the retail sales strength as evidence the slowing housing market is not yet hitting the wallets of consumers. They interpret the headline PPI data as evidence that inflation in the pipeline should be a concern. That is what I want to focus on.

I was listening to Rick Santelli this morning and he made a statement that I thought was dead on regarding the Core data that the fed seems to love so much. Let me first explain how this works.

Headline # ---> shows the total data for the specific report type

Core # ---> excludes food & energy because these items are thought to be volatile #'s (sudden & sharp movements) that skew the headline # and don't give an accurate look into how the overall economy is doing on the specific report type
*the fed has been known to follow the core dataset more heavily for policy actions

The argument is WHY THE HELL SHOULD WE REMOVE THE FOOD & ENERGY ELEMENT OF THESE DATASETS? You eat right? You use energy to heat your homes & fill up your gas tank right? They are a part of everyday living right? So, why exclude them when monitoring if inflation is in-line or out of control? Here is what some of the fed governors say about this (via Real Time Economics: WSJ Blog):

Cleveland Fed President Sandra Pianalto ---> "The reality of rising oil and commodity prices is evident, and my Federal Reserve colleagues and I have been clear that we believe the impact of these influences will dissipate over time. But until our beliefs are validated by the data, there is a risk that the public’s trust could erode and inflation expectations could move higher."

Dallas Fed President Richard Fisher ---> "Both food and energy have had a steep upward tilt for the last three years in a row. Under those circumstances, I’m personally reluctant to put complete faith in the core measures because they may be removing more signal than noise."

Berkeley Professor Brad DeLong says:

If the rise in inflation is thought to be (a) transitory and thus (b) self-limiting, the Fed would prefer to let sleeping dogs lie rather than hit the economy on the head with a brick.

However, when increases in inflation are confined to (i) energy and (ii) food prices, odds are that the increase is transitory and will be self-limiting. Hence the concept of "core inflation." If the Federal Reserve concludes that the current rise in inflation is transitory and self-limiting, it can point to the core inflation number as a principled excuse for not hitting the economy on the head with a brick.

Back to real world Rick Santelli: this morning Rick made a statement to the effect that the Core # is a somewhat old school methodology for a time where a spike in energy and food prices was sudden and temporary. Are higher food & energy prices transitory (not lasting) and self-limiting (limiting its own growth by its actions) as Prof. DeLong says? On the contrary, I would argue that food & energy prices have been high for years now and is part of the new world that we live in as globalization plays a key role and the US economy matures. So shouldn't we put less weight on the core # and NOT exclude these elements that seem NOT to be just a temporary spike?

Look at what is going on in the mind of Axel Weber, a governing council member of the European Central Bank (via Bloomberg):

European Central Bank governing council member Axel Weber yesterday said policy makers might need to increase borrowing costs to keep inflation under control.

"If risks to price stability are threatening to materialize, monetary policy can't lose sight of its primary mandate -- even if that means no longer supporting the robust economy or becoming restrictive," Weber, who also heads Germany's Bundesbank, said in the text of a speech in Munich. There may be an "additional need" to raise interest rates, given the "expected acceleration in euro-region inflation over the coming months."

Wow! A central bank member that actually stands by the stated mandate of the governing body! It's clear that Ben Bernanke & our Fed has chosen economic stability / growth over price stability and inflation; as evidence by the aggressive 1/2 point rate cut at the expense of future inflation in the pipeline and a very weak US dollar.

Ive said it before; read my post "Moderating Inflation? I Don't Think So" where I discuss this in more detail. I think the days of ultra cheap money and deflation are over. I think we are headed for a longer term period of higher rates and inflation as the global boom continues.

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Wish List: More Rate Cuts OR Strong Data?

A: You can't have them both! Interesting topic to touch on as we head closer to Friday's all-important jobs report! That report will be a leading indicator for the fed funds futures market to re-price expectations of future moves by the fed! While the stock market rally of the past few weeks has been based on one part by more expected rate cuts, what is it that the markets really want? Do we want stronger data showing a resilient US economy holding on and not as bad as first thought OR do we want weak data that will give the fed more leeway to cut rates in the future? With stocks already pricing in a few more rate cuts, should that data come in stronger than expected we may get a selloff as equities take back future rate cuts!

It's strange to have an environment where weaker economic data will be viewed as a buying opportunity in advance of future fed rate cuts! But then again, there is nothing normal about how stocks move. There is an emotional element at play here, with bad news being absorbed quite well and expectations for an accommodating fed. To understand what I mean, look at how the markets reacted to the news on Citigroup, Netbank, and UBS in the past week:

CITIGROUP ---> Admits a $5.9B loss and write-down due to subprime related mortgage market investments gone bad; stock gained 2% on news

UBS ---> Admits a $3.4B hit to earnings; stock gained 3.2% on news

From USA Today:

Two of the world's biggest banks, Citigroup (C) and UBS (UBS), announced multibillion-dollar third-quarter write-offs Monday. But instead of dampening spirits, the red ink stoked enthusiasm among investors who appear to believe that the meltdown in the subprime mortgage market is over.

The stock of Citigroup, which announced a $5.9 billion write-down, closed at $47.72, up more than 2%. The stock of Zurich-based UBS, which announced a $3.4 billion hit to earnings, gained 3.2% for the day.

NETBANK ---> Internet banker files for bankruptcy as regulators take over accounts. The bank's failure this year was the result of margin compression from an inverted yield curve, fewer mortgage originations, and demands to repurchase delinquent loans, according to a bankruptcy court filing.

Lets go back. When this credit squeeze first hit the media and became a big headline risk to stocks, I wrote a post titled "Should The Fed Step In & Save The Credit Markets?", and dug deep to my past experience trading and following the markets to state very clearly:

LET THE COMPANIES WHO MADE BAD BETS STEP UP TO THE PLATE, PUBLICIZE THEIR LOSSES, TAKE BOOK VALUE & LIQUIDATE BAD HOLDINGS IN ORDER TO WRITE OFF THE LOSSES! ANNOUNCE A RE-STRUCTURING EFFORT AND PUBLICIZE EXACTLY WHAT IS BEING DONE TO FIX THE PROBLEM & BRIEF INVESTORS ON THE FUTURE DIRECTION OF THE COMPANY

By coming out in this manner and letting the current value of their holdings to actually trade and liquidate would allow the financial markets to weed out the bad bets made and the losses to be written off. While it will be painful for the companies and their investors to do this, it will be better for the overall credit mess and it will allow the markets to function more effectively in re-pricing the risk so that we can move past the mysterious problems that we now face. It’s the uncertainty right now that is killing equities.

This is why the banking and brokerage sectors have cheered the coming out of awful earnings news from Citigroup & UBS. Stock markets obviously feel this credit mess is contained and that the fed is there to help if things get bad. But what if that help is short-lived or limited due to a US economy that is not as weak as expected? It's a great question that will be answered on Friday with the jobs report: STRONG JOBS and there goes the expectations for aggressive rate cuts; WEAK JOBS and that should solidify at least another 1-2 rate cuts by years end. You know my thoughts with longer term inflation out there and the currency, stock, and commodities markets virtually telling the fed to take it easy with more cuts!

What would you rather have? STRONG ECONOMY or MORE RATE CUTS?

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Moderating Inflation? I Don't Think So...

A: Barry Ritholtz often argues about the flaws in the datasets that the fed uses to monitor inflation. These statistics, issued by the BLS/BEA/COMMERCE DEPT, has shown inflation as moderating here at home which allowed the fed to act aggressively in preventing the US economy from falling into a recession with their 1/2 point rate cut a few weeks ago. But I and many others out there have argued for some time that inflation IS out there, there is now a buildup of inflation in the pipeline, and to ignore food/energy in the so called CORE datasets is to turn your head away from reality! You want to see inflation? Look at what Dean Foods CEO said today about the current environment to get an idea about what it really is like out there!

First, why do I talk about this if this is a Manhattan real estate site? Here's why:

INFLATION RISKS ---> COMPANIES RAISE PRICES OF GOODS AS COSTS RISE ---> COST OF LIVING INCREASES ---> SPENDING POWER DIMINISHES ---> FED MUST RAISE RATES TO COMBAT INFLATION ---> AS RATES RISE, THE COST OF DEBT RISES ---> BOND YIELDS RISE TO REFLECT THIS MACRO ADJUSTMENT ---> LENDING RATES & CREDIT RATES RISE ---> AFFORDABILITY GOES DOWN

If you don't understand the macro effects of a high inflationary environment, then you probably will have a hard time connecting the dots to how it can ultimately trickle down to investment classes like stocks or housing. It's all connected.

THE FED WAS ABLE TO CUT RATES TO 'FORESTALL ADVERSE ECONOMIC EFFECTS' BECAUSE:

a) inflation data showed moderation (while some argue about the makeup of these models)
b) jobs data showed weakness indicating an adverse effect on US economy
c) housing woes continued to pose threat to overall economy

But I ask? HAS INFLATION REALLY MODERATED? Look at energy costs, look at overall housing prices in the past 5-6 years, look at food prices, look at health care costs, look at commodity prices showing whats in the pipeline! To say inflation is NOT a problem is utterly ridiculous! It's this train of thought that leads me to believe the fed is VERY CLOSE to being done with rate cuts, and that we are in a longer term trend of rising rates. I mean, since when is a fed funds target rate of 4.75% restrictive to economic growth?

Here is real world evidence of inflation via the CEO of Dean Foods:

"The third quarter has been particularly challenging as dairy commodity costs have risen sharply, hitting all time highs," said Chairman and CEO Gregg Engles. "This is by far the most difficult operating environment in the history of the company, reinforcing the importance of the long-term strategic initiatives we have underway."

The company, which makes products such as Silk soy milk and International Delight coffee creamer, said that increasing commodity costs have materially reduced profits. They also have hurt sales as customers react to higher prices

Now I understand this is one company and that we can't predict something as dynamic as 'inflation trends' from any one CEO. But this is just another example of how government statistics don't reflect what is going on in the real world. The fed loves to watch the CORE PCE as a measure of inflation, which measures prices paid by individuals for goods other than food and energy; here is that chart going back to the late 1980's:

Recall the inflation problem of the late 1980's, as indicated by Core PCE # above 4, and how the fed raised the fed funds rate (the same one they just cut to 4.75% two weeks ago) to just below 10% to combat runaway inflation. While I am not predicting such an extreme, I do think inflation in the pipeline is a problem. Its not on the surface yet and the fed is clearly taking a 'wait and see' attitude about this problem. If the problem doesn't go away, rates will HAVE to go up.

Is inflation out there? Do you think your cost of living has increased in the past 5 years OR no? Here are some others take on this incredibly confusing situation.

There's No Inflation: If You Ignore The Facts - (Newsweek via The Big Picture Link) -

Imagine that a cardiologist told you that aside from the irregular heartbeat, the stratospheric cholesterol count and a little blockage in your aorta, your core heart functions are just fine. That's precisely what the government's cardiologist - Ben Bernanke, chairman of the Federal Reserve - has just done. The central bank is supposed to make sure the economy grows fast enough to create jobs and make everybody richer, but not so fast that it produces inflation, which makes everybody poorer.

Catch that bit about "core inflation"? That's Fedspeak for: inflation is under control, unless you look at the costs of things that are going up.

Speechless on Core CPI - (The Big Picture) -

I wonder what people will be saying when the September CPI comes out. It will be substantially higher due to soaring energy and food prices this month. Oh, wait, that's not in the core. (Nevermind). Gee, I wonder why the Fed prefers Core PCE as an inflation measure -- instead of what is occurring in the real world?

Picking an Inflation Measure and Sticking With It - (Portfolio.com) -

The Fed has said, quite consistently, that the measure of inflation it cares about most is core inflation, as measured in nominal dollars, ex food and energy. You can argue with that decision, but once they've made that decision, I'm not a fan of suddenly deciding when food and energy prices rise that, oh deary me, they do matter for monetary-policy purposes after all.

CPI's Lie on Household Inflation Doesn't Wash - (Bloomberg) -

The U.S. consumer price index continues to be a testament to the art of economic spin. Since wages, Social Security cost-of-living increases and some agency budgets are tied to it, the government has a vested interest in keeping it as low as possible.

Yet your real cost of living -- what you keep after taxes, medical bills, college expenses and other household costs -- is probably much higher than the 2 percent annual rate the government reported in July, showing a slight decline.

The Llama of Lame - (Long or Short Capital) -

First of all, as far as I can tell food and energy are the only two items you should NEVER exclude from an inflation index. Tell your wife and kids they can have everything in the consumer basket except food and energy and you will quickly see that they are actually the two MOST important and indispensable factors in the CPI.

This will come back to bite you but not nearly as much as it bites us. The cheaper the dollar gets the more expensive all our imports get, inflation will rise faster than you can statistically manipulate it and when that happens expected inflation goes through the roof (which as you yourself have pointed out many times is by far the most serious threat to economic existence). Then the only way out will be interest rate increases as swift and severe as all the cuts have been.

Interesting food for thought from those that are on this side of the argument. I hope I'm wrong. One last thing, there is an argument that housing is deflating and is another example of how there are no inflation problems out there. There is one major item that is being left out of this affordability equation: RISING RATES! Housing has underwent an unsustainable rise in pricing over the past 5-6 years; over the past 3 years, rates have been rising offsetting any recent decrease in prices (prices go down, but cost of loan goes up). As home prices across the nation correct towards the norm, any affordability gained has been wiped out by a combination of rising rates and side effects of the recent re-pricing of risk / dysfunction in the secondary mortgage markets!

I wouldn't consider the housing correction as deflationary because the cost of living has not declined in lock step with pricing. Where I do see deflation is in consumer electronics, apparel and autos; hardly anything that I would consider as essential to daily living!

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Fed Totally Dissing Inflation / Dollar

A: There is a very heated debate in the macro economic blogosphere about whether Ben Bernanke & Co. are doing the right thing by aggressively lowering the fed target rate as a preventative measure to fend off any recession, or doing the wrong thing by giving wall street what they want at the expense of future inflation and the weak US dollar. Stocks like inflation. Inflation is a side effect of a hot economy, or hot global economies, and when you see record prices in energy and other commodities its hard to ignore why stocks continue to do well; especially with fed rate cuts on their side. But is all this good for us in the end? Is housing even going to be helped by the rate cuts? Is the weak dollar good for the US?

For anyone whose been reading my blog for past years, you know that I lean heavily on macro economic discussions in the hopes of understanding what may be going on to drive stocks, housing, commodities, etc.. There is never a dull moment in this arena, especially in the past few months.

The US dollar is whitering away and inflation is no where near gone as the fed decided to put two of their stated mandates on hold (keep inflation in check and price stability) and focus instead on economic sustainability. What does that mean? It means the fed made it absolutely clear that the threat of a US recession was the #1 reason for their latest move in an attempt to "...forestall some of the adverse effects on the broader economy that might otherwise arise from the disruptions in financial markets and to promote moderate growth over time."

It was preventative and the unwanted side effects of making this bold move are:

1. Moral Hazard Issue - Did the fed give wall street what they want? Did they give the lenders too much liquidity and bail them out? Were the free markets unable to correct themselves that they needed this action? In my opinion is what August's awful Jobs data that gave the fed the opportunity to pull a move like this. Without that direct evidence of a slowdown hitting the labor market, the moral hazard argument becomes way stronger and the fed probably only cuts by 1/4.

2. Wasting Away of US Dollar - Anyone who has visited Canada or Europe recently knows how weak our currency is. It's as if the greenback has cancer and we are all watching as the currency whithers away. Good for stocks, bad for consumers and purchasing power. A weakening dollar will help corporate profits (especially those with businesses abroad) but will add to inflation concerns here at home down the road (and that means possible future rate hikes!). How low can this US dollar go before action is taken, or at lease inaction (no more fed cuts) is taken?

3. Steepening Yield Curve / Future Inflation - When the fed made its move, the bond market saw yields RISE, not fall! This is because with such a stimulative move by the fed, future inflation concerns become a very real problem and the bond market prices that in. Energy prices and other commodities soar helping to bring yields higher at the longer end of the curve. Here is a chart of what 10YR & 30YR Bond yields did right before and after the fed move:

For anyone that doesn't believe in inflation or the government's measure of it, just tell me whether the cost of living, eating, heating your home, filling up your gas tank, etc has risen over the past few years? If you say NO to those questions, please tell me where you live?

4. Longer Term Lending Rates DIDN'T FALL That Much - This is why you do NOT listen to the heads of mortgage companies, brokers, or anyone with a vested interest in you making a decision that puts money in their pockets. Everyone was on the bandwagon that if the fed cuts, all will be fine and dandy and lending rates will fall big time for a very popular loan product; the 30YR Fixed! This didn't happen and here is why.

For past 3 months, lending rates didn't follow the bond market as there was a re-pricing of risk in the mortgage markets; see my post that discussed this disconnect. During the height of this liquidity & credit squeeze, bond yields fell big time and lending rates rose significantly; thus, the disconnect between bond yields and mortgage rates due to perceived added risk of lending. However, with the latest fed move in target rate and discount window, it's clear that our central bank is doing what it is needed to stimulative and add liquidity to those in most distress; the lenders/banks/holders of mortgage backed securities. With this comes an increase in confidence, at least to some level, and the beginning of a return to a more normal relationship between bond yields and lending rates.

As you see from the charts above showing you longer term bond yields AFTER the fed move, they moved higher! That means little to no relief in longer term lending rates even with the fed rate cut. Those looking into short term ARM's, holders of HELOC's, and holders of credit card debt did see some relief due to the fed rate cut as both the Prime rate and LIBOR rate eased. All of this may have been an intended side effect from our fed, as 2008 poses a very big threat to nationwide housing and secondary mortgage markets when a record number of short term adjustable mortgages will reset to significantly higher rates. Those with resetting ARM's next year won't enjoy that much relief, even with LIBOR rate easing, because as Dan Green noted a ways back, there are CAP's set to how much your rate can jump and chances are even with this fed rate cut and relief in LIBOR rates, you are still near the top end of how much your mortgage can reset at.

For now, its BYE BYE to our US dollars and HELLO to future inflation risks in the years to come. I wonder, at what point does:

* $80+ oil start to HURT the economy?
* The weak US Dollar become a priority?
* The fed take a bigger picture stance towards future inflation risks?
* Housing inventory build reverses course giving fed ammo to raise rates?
* ECB takes stance against strong Euro for fear of it slowing Eurozone economies?
* Higher commodity prices fully trickle down to consumers?

Here are some interesting reads about these topics for those wishing to learn more sides to the story:

Inflation is Dead? Part II (The Big Picture)

Eurozone Slows (Calculated Risk)

50bps Cut May Be Too Little Too Late (RGE Monitor - Professor Nouriel Roubini)

Forward Rates & Inflation Expectations (Econbrowser)

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Fed Acts! Cuts By 1/2 Point!

A: The fed decided to GO VERY AGGRESSIVE and cut the target rate by 1/2 point PLUS the discount window by 1/2 point! Holy cow! Quite a surprise and stocks are obviously rallying big time on this news! With such a move, I question how bad this credit mess really is on effecting the US economy and continuing the housing downturn!

Wow! This was my least likely of options as we all learned a bit about Ben Bernanke today! Here are side effects:

1. YIELD CURVE STEEPENS - Short term bond yields fall & long term yields rise!
2. STOCKS RALLY - Stocks get what they wanted!
3. US DOLLAR FALLS - Dollar index under pressure
4. OIL HITS NEW INTRADAY HIGH - Not a surprise with such a stimulative move
5. LOWER HELOC RATES - Expect Prime rate (tied to HELOC's) to fall for first time since last July. Expect lending rates to fall as well with this move.

The accompanying statement mentions the "return of inflation concerns" and it appears that this VERY AGGRESSIVE MOVE IS A TWO AND THROUGH MOVE! I'll have to fully read the statement to discuss that likelihood more.

Some excerpts from the fed (read the full FOMC statement here):

"the tightening of credit conditions has the potential to intensify the housing correction and to restrain economic growth more generally"

"Today's action is intended to help forestall some of the adverse effects on the broader economy that might otherwise arise from the disruptions in financial markets and to promote moderate growth over time."

"Developments in financial markets since the Committee’s last regular meeting have increased the uncertainty surrounding the economic outlook. "

Notice the preventative nature of these statements; recall my "Expect A Preventative Rate Cut" post? Basically the fed decided to do its actions NOW and STOP the markets from pricing in future moves! The markets love this with a huge stock rally but how they feel about it when things settle down and they realize that future cuts seem unlikely is yet to be seen!

Inflation hawks are going to be criticizing this move BIG TIME; including me. Was 1/2 point on the fed funds rate needed? The fact that they did makes me worry a bit about short to medium term economic impact. WOW!

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Big Fed Day: Rate Cut Likely But...

A: Ben Bernanke and Co. will decide at 2:15 EDT today what their course of action will be, if any, for monetary policy that affects the overnight lending rate banks charge each other and which sets the tone for either restrictive or stimulative policy towards the US economy. In my opinion, the stock market has already priced in a 1/4 point rate cut and future cuts into equity prices and will ultimately selloff when they don't get as aggressive a move or statement when the fed releases their decision later today. Here's why.

Here are the main reasons why the fed will only cut by a 1/4 point, if at all, and not release as aggressive a statement in regards to future rate cuts:

Inflation Risks - Oil is at record highs, Gold is over $700/ounce, and other commodities are at highly elevated levels keeping longer term inflation risks from dissolving. Alan Greenspan even went on record recently as stating that long term inflation remains a very real concern and that he worries about double digit fed funds rates at some point down the road. The fed is still stuck between a rock and a hard place and can't risk aggressively lowering the fed funds rate and pumping too much liquidity/stimulus into US economic systems and ultimately making long term inflation risks even worse.

Weak US Dollar - The US dollar will gain some strength against European currencies if the credit mess hits over there and the ECB sees a need to stop raising rates, reverse course and actually lower rates. But that is yet to be seen. The credit crunch hitting Northern Rock in the UK has told us that Europe is not immune to current risks and that they may be next. As far as strength in any currency, there will be little if the overall economy gets hit; a strong economy yields a strong currency. We know that the US dollar has been super weak and I just don't see how our fed could start to embark on a aggressive rate easing campaign, further weakening our currency. Our currency could see gains on other currencies though IF this credit contagion ends up hitting global economies which will cause central banks to lower rates and global currencies to give up some gains against the US dollar. It seems we were first in this mess and could be first out of it too.

Stocks Still Near Record Highs - Major stock indexes are only 5-6% off record highs. Does this sound like an environment ripe for major rate cuts to you? If there were no chance of a fed rate cut, stock indexes would probably be 2-3% lower! There is already a premium priced into stocks for today's expected rate cut.

Avoid Recent History - One major reason we are in this credit mess (which is the main reason for US recession fears right now) is because of ultra cheap money and Greenspan's aggressive action on monetary policy bringing the fed funds rate down to 1%, keeping them there for too long, and not raising them back up aggressively enough (2 years of 1/4 point rate hikes is as slow a course of action as you can get). How could Bernanke and Co. ignore the risks of recent history repeating itself by aggressively lowering fed funds rate again; they can't and won't!

There are also real reasons for the fed to take action knowing that any fed move today will not effect the overall economy for a good 8-12 months. A few of these reasons include the very weak jobs report that came out a few Friday's ago, the nation wide housing problem, illiquidity in credit markets (which a cut in discount window can help a bit), and expected side effects to US economy and consumer spending. Some argue the fed is already behind the curve and about 2-3 rate cuts too late, while others argue that inflation fears are far too real to warrant any move in the fed funds rate. Very tough position for Ben Bernanke and his colleagues.

Here is my call. The fed will:

1. Cut Fed Funds Target Rate 1/4 Point (25 basis points)
2. Cut Discount Window 1/2 Point (50 basis points)
3. Issue a more conservative statement than most expect and mention they will be 'ready to act' as needed and determined by incoming data. Mention that inflation risks still remain in some way, shape or form.

I think the stock markets will ultimately selloff on the move after pricing in this action already. I do NOT think the fed is about to embark on a long term rate easing campaign! I think they will cut rates by a total of 50-75 basis points at most, bringing the fed funds target rate down to 4.5% or so, as a preventative measure to cushion any economic slowdown that does result from the credit/liquidity crunch. Not only that, but it is very likely that we won't stay at those levels for long, as inflation risks will force the fed to raise rates more aggressively down the road (a longer term view of fed funds target rate).

If I'm wrong, and the fed doesn't cut the target rate today by 1/4 point, I think the move will be NO CUT AT ALL! I think those expecting a 1/2 point rate cut are way off, and I will be very surprised and worried if that happens. Here is what to expect for all scenarios and my percentage bet for each:

65%: Fed Cuts Target Rate 1/4 Point + Discount Window Cut ---> Initial jump in stocks and then selloff
30%: Fed Doesn't Cut Target Rate + Discount Window Cut ---> Stocks selloff
5%: Fed Cuts Target Rate 1/2 Point + Discount Window Cut ---> Stocks rally

All in all, a very important day to see where our monetary setting body stands right now and for future moves that may be in the works.

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Expect A Preventative Fed Rate Cut

A: Tough tough call here but something I must discuss as there is now statistical evidence that the US economy is slowing (read "Jobs Weaken Big Time...") amidst the turmoil in the credit markets. However, and its a BIG HOWEVER, there are still reasons NOT to cut rates that I will get into here. What will the fed do on September 18th, which will prove to be one of the biggest and most important fed meetings of 2007? I'm putting my bets on a 1/4 point rate cut, (25 basis points) PLUS another cut in the discount window, as preventative medicine to cushion the severity of any slowdown that is to come. Your thoughts?

First, let me explain why a fed rate cut will NOT necessarily mean a drastic reduction in lending rates! Right now, we are living in a new world. A world that is in the process of re-pricing risk as investors determine what type of risk demands higher premiums and what type of risk doesn't. In this new world, LENDING RISK is demanding higher premiums because quite simply it is filled with uncertainty and backed by a secondary market that is now illiquid and void of buyers. This is the simplest way for me to explain what is otherwise a very complex situation. For more in depth on this topic, read:

* How Mortgage Backed Securities Work
* Wells Fargo Rates Jump To 8% Overnight
* RMBS Markets Explained
* It's A Risky New World / Credit Spreads

Now, while lending risk is running under it's own set of guidelines, there has been a disconnect between the relationship it has with bond yields; specifically the 10YR bond yield. Recall in my AUGUST 4th post about the risky new world where I clearly stated:

Relating this to the mortgage markets, while short and medium term US gov't treasury yields are falling fast due to a flight to quality as stock prices fall, the rates on mortgage products are NOT falling at the same pace! This is because mortgage debt is now MORE RISKY than treasury bond notes and therefore demands a HIGHER RISK PREMIUM to gather investors; i.e. higher yields.

Take a look at the chart on the right which is not the most accurate for NYC lending rates but is good enough to prove the point I just made. Notice how the relationship between 10YR Bond Yields & 30YR Fixed up until the end of July (marked with two 'X's and a line on each chart where the disconnect begins) had similar movements. Then something happened! RISK! Subprime defaults hit wall street and the secondary mortgage markets ceased up. The resulting uncertainty hit stocks hard and caused bond yields to FALL (as investors fled to quality of US gov't treasury's), while the increased risk in mortgage markets ROSE (causing lenders to raise rates on loans, tighten standards, and limit options of loan products to consumers)!

Again, this is the simplest way for me to explain what is going on! So, in this new world what does the fed do? Well, there are two ways to think about it.

REASONS TO CUT RATES

* Inflation Moderating - Yea, but US metrics have been argued to be flawed. Commodity & Energy prices still very high. Inflation threats still persist. Arguments on both sides here.

* Prevent Recession - Cushioning move in monetary policy to help soften the hit when/if it comes

* Housing - Housing is still awful across much of the nation but we are yet to see a trickle effect in consumer spending. We are seeing effects in jobs now. Will fed be pro-active and cut ahead of the curve in anticipation of a slowdown in consumer spending as a result of housing downturn?

* Jobs Slowdown Three Months Now - Statistical evidence and the most compelling to warrant a rate cut. August jobs data was outright awful and the prior two months were revised down. This means the slowdown is in place already and fed is behind the curve.

REASONS NOT TO CUT RATES

* Moral Hazard - Fed bailout may prompt risky bets in future

* Weak US Dollar - Cutting rates will further weaken our currency? There are some arguments for the flip side though.

* Stocks Expect It & Priced In - Stock Indexes are only slightly off record highs as they priced in a rate cut. The fed should NOT give the markets what they want for fear they will selloff if they don't get what they want. In other words, the fed should NOT do what wall street expects. If we get no rate cut, we get a selloff!

* More Stimulus = More Inflation Risks - Cutting rates and pumping umph into the economic system could cause inflation to re-ignite down the road and energy prices to rise even further.

* Globalization Cushions Recession - Strong global economies could help cushion the downturn by itself. It may help corporate America, but the consumer is a whole new issue!

* Inflation Still A Risk - Sure, it is moderating at home, but how long will it last with oil at record highs and commodity prices still high! At some point will this re-ignite?

Cutting the fed funds target rate will NOT immediately turn around housing woes. It will NOT solve the illiquidity in credit markets and secondary mortgage markets. It will NOT solve problems with buyouts that fail to close. It will NOT solve the debt problems we have. It will NOT cause lending rates or the all-important LIBOR rate (to which adjustable mortgages/credit cards are tied to) to reverse course significantly!

You can see how tough a call this is for our fed and why this meeting is so important! The accompanying statement is just as important as the fed action is because it will tell us more what the fed is thinking in terms of future actions and their thoughts on the economy in general.

MY CALL - The fed will cut 1/4 point and bring fed funds target rate to 5%. Stocks will rally slightly as they really want a 1/2 point rate cut. I think the fed will also cut discount window again by 1/2 point to help liquidity in banking system a bit. If it's not 1/4 point, I'm betting on NO cut at all. The 1/2 point rate cut option is my least expected option. I would break it down like this:

60% CHANCE ---> 1/4 point cut
30% CHANCE ---> NO CUT
10% CHANCE ---> 1/2 point cut

Questions I have are how this will effect lending rates and the LIBOR rate, if at all. Since lending rates are operating under a different set of rules now, it's naive of us to think that past relationships between fed rate cuts and lending rates will prove true this time around!

YOUR THOUGHTS? WILL THE FED --->

1. CUT RATES 1/4 POINT
2. CUT RATES 1/2 POINT
3. NO CUT AT ALL

??????????????

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