Jesse Eisinger has a strong piece in today’s WSJ about the slowing economy and risks to the market: What if Housing Hare Becomes a Tortoise?
I chatted with Jesse about two major themes I have been beating to death: How an obvious but ignored idea (inflation, slowing housing), can suddenly take over the market.
You can see these themes in a few recent posts: "Amazing, isn’t it?" and "The Fed’s New Conundrum: Slowing Housing."
Here’s a quick excerpt:
Sure, the stomach-churning downturn in the last several sessions — in U.S. stocks and then the bubblicious commodities markets — was fast. But it wasn’t surprising. The things that should have mattered didn’t for the longest time, and now suddenly they do.
To figure out where the birds will come to roost, look homeward. Housing has been the key sector driving consumer spending, employment and therefore the markets. It was trending south long before last week’s selloff, but investors have yet to fully appreciate its implications.
The Federal Reserve’s rate-raising campaign has clearly started to have an impact, as long-term rates are moving up. And oil’s relentless rise has finally started to bite. Crude’s creep seemed merely worrisome when it hit $40 a barrel, troubling at $50 and ominous at $60, but by the time oil hit $70, investors seemed to forget about it. But the airlines and distributors that have been tacking fuel surcharges onto their wares didn’t forget, and now inflation is on the horizon.
The rapid recent swoons are only the latest evidence of how dominated the markets are by aggressive speculators, especially the trend-following hedge funds that play the futures markets. These funds have been whipsawing the global markets, researcher Bridgewater Associates pointed out in a note this week.
Yeah, I’m quoted in it — but you have to go to the full article to see that . . .
Source:
What if Housing Hare Becomes a Tortoise?
Jesse Eisinger
May 17, 2006; Page C1
http://online.wsj.com/article/SB114782904886854950.html
The complete article is available at Post Gazette
http://www.post-gazette.com/pg/06137/690861-28.stm
And a housing slowdown this time might actually be different:
“I have mentioned that the Fed has actually targeted volatility, desiring to reduce it so that investors take more risk. Remember, taking risk is inflationary while avoiding it is deflationary. A prime example of the Fed doing this is ARMs. Remember when Greenspan pointed out to home-owners how much money they were giving away in interest by holding fixed mortgages instead of flipping into adjustable rate mortgages? Why was this done?
When a home-owner holds a fixed mortgage, they hold an option, a very valuable one. At any time they can refinance when rates go lower (for a fee). This option makes them long volatility, a position home-owners have held for decades. Lenders are short this option. We have explained this in detail when talking about Fannie Mae (FNM): when prepayments occur because of refinancing, FNM must rebalance their duration and buy bonds as they are rising in price (yield falling). The more rates move around the more FNM (or any lender holding a mortgage as an asset), the more FNM must adjust; each time they do it is a cost.
When home-owners en mass flipped into ARMs, they became sellers of volatility (they gave up this option) and lenders became long volatility (exchanged convexity risk for default risk). The absolutely massive amounts of ARMs significantly reduced volatility in the bond market, which transferred into all markets.
The Fed used the home-owner to reduce volatility. VAR went down and investors took more risk.”
http://www.minyanville.com/articles/index.php?a=10286
“About $200 billion of adjustable-rate mortgages will be reset this year, according to Calabasas, California-based Countrywide.
Next year, $1 trillion of floating-rate loans are due to reset.”
http://guambatstew.blogspot.com/2006_05_01_guambatstew_archive.html
Interesting point GS. So, I don’t recall Greenspan saying that but it would jive with the times. I say that because I’ve done some digging into the mindset of the Fed during the popping of the equity bubble and post 9/11. It appears extremely likely the Fed was very frightened about a deflationary depression. Especially with the 9/11 shock added in. Did they realize they might be in 1929 but with the twist of 9/11 shutting off the economy even more? If so, that is likely why they overshot on rate cuts. And, they likely did it consciously although admitting this would mean the Fed haters couldn’t call them clowns.
All of those rate cuts didn’t stimulate the economy until the tax cuts gave them a home. Would they have ultimately saved us without tax cuts? So, I would assume Greenspan, et al, knew they were stimulating real estate and pushing consumers to ARMS was stimulative to the economy. That was their mission. Yet, on the back end they needed to manage the risks with the hope of averting the future disaster they averted in 2001. ie, Biding time in hopes we could smooth things out over time.
So, the $64 question for the Fed haters is this. If the Fed did not lower rates to where they did post 2000 and 9/11, would we be in a deflationary depression today? And were their efforts an attempt to divert such a scenario? And, if so, were they biding time and hoping global growth stimulated by low rates might alter the ultimate outcome? And, knowing this, is this the reason they were so slow to raise rates because they wanted the global economy to be as healthy as possible before shutting off the spigot? ie, Err on the side of inflation because the ugly outcome isn’t inflation, it’s deflation? And will they be successful? No one will ever know. But, if an average joe can hypothesize this, weren’t these discussions likely part of the equation?
Remember, the Fed may appear as buffoons if you only look at one side of the equation. And, also remember, the Fed has massive resources of extremely competent people and research beyond the political appointments. ie, We musn’t assume it is a bunch of appointed clowns making decisions. Regardless of what is discussed in the FOMC meetings, which are largely ceremonial, what were the private meeting discussions surrounding this topic before and after the FOMC meetings that they don’t want us to hear?
B – i think you raise some important issues that will be debated for years to come as this thing shakes out. i personally don’t think the Fed should be in the business of setting interest rate targets. why should we think the Fed is more informed than the bond market?
this whole mess started with LTCM and Asian currency crises when the Fed eased to help stem any systemic instability. it was debatable whether they should have done anything, but they definitely ignited the equity bubble which they had to stem by tightening which in turn deflated the bubble. which caused them to ease which ignited the real estate and commodity bubbles. now they are tightening to deflate these bubbles and we are in the midst of this process which will probably not end pleasantly.
it seems like they are always behind the curve and are constantly cleaning up their own mess.. why should they be so active trying to manage rates when we have a highly liquid free bond market to do the same thing?
guess where the FF rate was prior to LTCM.. 5.50%
it’s been a round trip and we probably would have been better off with a Fed that did nothing.. there is nothing wrong with letting the free market adjust the imbalances. so what if consumers have to take a little medicine. it makes us a stronger economy in the long run.
exactly. set short rates at 3% with no detours to 1% or 5% and get out of the way
One particular sentence really caught my eye….”The rapid recent swoons are only the latest evidence of how dominated the markets are by aggressive speculators, especially the trend-following hedge funds that play the futures markets.”
When our hedge fund was trading oil futures in 2002-2003 there were a handful of major players. You knew everyone and, for the most part, they were seasoned, rational investors following a particular investment thesis.
The number of hedge fund guys/girls that I know that are chasing commodities is mind boggling. Calling yourself a hedge fund does not make you a smart investor.
I’m with B – this might end very badly.
I remember Greenspan making the case for ARMs because I was refinancing at the time. Fixed rates were at 5%, and the guy was arguing that homeowners should give up the certainty of 5% for the next 30-years in exchange for a percent lower rate. I thought he was out of his mind.
You can read Greenspan’s ARM sales pitch here:
http://www.federalreserve.gov/boarddocs/speeches/2004/20040223/
I remember at the time people were scratching their heads wondering what he was talking about since interest rates were so low. One of the interesting aspects of changing mortgage patterns is a return to some of the risks in housing finance that exacerbated the Great Depression. Mortgages at that time were primarily interest only, short term, high rate with balloon payments. New amortized, lower rate, longer term, government backed finance products were introduced to support the collapsing housing market. Numerous observers have been warning for some time that the increase in the use of ARMs, IO and Option ARMs during a period of very low interest rates, not to mention increases in subprime lending and very loose lending standards, could undermine some of the post Depression stability in the housing market.
Very important points you make. You know, there are those who say the Fed is destructive in its policies and there are strong arguments to support it. I think that argument is one that will rage till the end of time. Or till the end of the Fed. :) The bond market is definitely not signaling inflation IMO. In fact, to the contrary, the bond market might be signaling that recession or worse is imminent. We could be in a recession right now for all we know. The data is starting to deteriorate rather noticably. One reason why I would rather let the markets pop any commodity bubble and the Fed actually look at coincident data. ie, We don’t need any Fed “piling on” in this precarious situation by targeting commodities. They always fix themselves as supply and demand.
I would argue that “taking a little medicine” is something that I would prefer to avoid at all costs in situations of extreme sickness. ie, Mild imbalances or normal business cycle slow downs, I support letting the markets maneuvering through the cycle themselves. In situations of extreme possible crises such as now, I’d rather have the Fed pumping like mad to keep 50% of the population from ending up destitute. Obviously an exaggeration….er….maybe. But, then, one could argue that very action of Fed involvement creates a self fulfilling prophecy as you point out.
I’m quite nervous in actuality. I can survive a mess but I can imagine a plausible outcome that is very, very nasty for a reasonably long period of time. And I haven’t felt that way my whole adult life…..that is, until 2000 and now. ie, I am not a perma-bear and I am still super bullish on America long term. So, I guess all we can do is keep doing what we are doing. I think many Americans feel something isn’t right even if they don’t know what it is. All of way down the food chain including those who couldn’t spell economics.
Btw, isn’t it rather ironic that it is mostly hot money coming out of America or American hedge funds or American banks that are driving us to the precipice of economic crisis by jamming commodities through the roof? Causing the Fed to ponder raising rates till they choke off growth? All in the name of capitalism. lol.
Guambat stew, interesting point.
re: the WSJ article and risk. On the second page of that article, he mentions that 11% of loan officers say that they’ve lowered their lending standards in response to the slowdown in mortgage applications.
B, maybe the fed deflected a depression (maybe something not so bad), but at what cost? Thousands of homeowners have mortgages they can’t afford when the interest rates rise. They and the banking system will be hurt if they default. The debt-fueled consumption binge was probably no help to the economy in the long run but it certainly increased the trade imbalance in the short run. Arguably, they’ve put the dollar at risk. Avoiding another great depression might be worth all the cost, but deferring a recession for a few years? Not worth it.
B – interesting analysis. The only point I (strongly) disagree with is
“All of those rate cuts didn’t stimulate the economy until the tax cuts gave them a home. Would they have ultimately saved us without tax cuts?”
For most Americans, the tax cuts were a non-event. It was all rate cuts. We got a tremendous mortgage rate, then a equity line at prime minus 1%. With the house, credit card offers at 0% POURED in. Hell, 3 years later, we still have some $ floating out there at 0%. We also have a Subaru financed at 1.9% for 63 months (about 50 left to go).
The tax cuts didn’t have sh%t to do with it.
The Fed has a different goal than the bond markets. Investors in the bond market are trying to make money. For the most part, I doubt they analyze the effect of their actions on the economy as a whole and change theri behavior if they think it would cause a recession (even if doing so might actually be more profitable for them). Many foreign central banks are using the bond market to manipulate the currency market. Their goal is to maintain exchange rates. The Fed is the only player that is actively trying to control inflation and growth. Whether they are better informed or not doesn’t matter. With a different goal, their actions will be different.
The evidence suggests that the Fed does help stabalize the economy. Prior to WWII, there were boom/bust cycles that were fairly severe and lasted about 18 years. Since then, the business cycle has moderated somewhat. There hasn’t been a severe recession for over 50 years now.
The mistake the Fed has made recently is ignoring asset bubbles. They should be actively reminding people that prices can’t go up forever. The stock bubble wasn’t so bad, because most people still didn’t own stocks and mostly you couldn’t lose more money than you put in. The housing bubble can destroy the US economy (but almost certainly won’t cause anything worse than the great depression, and it probably won’t even be that bad). People have an emotional attachment to their home. People have to live somewhere. 70% of the population owns a home. You can lose $100k-$200k on a $20k downpayment. People that can’t afford to sell their home because of their negative equity can’t move to change jobs. I think it borders on criminal negligence for the banking regulators to have not reminded people that if they can only afford a house because of record low interest rates, someone like them won’t be able to afford it at the same price 5 years later. The Fed should have tightened regulations in the mortgage industry 3 years ago. Now it’s too late. The options are inflate out of the mess or let housing collapse and take down the economy with it.
While the tax cuts weren’t directed at the middle to lower income people, there is a very valid argument to be made that jobs are created by those with a disproportionate amount of assets. Ditto with tax cuts directed towards corporations. If you wanted tax relief to buy a new set of shoes for your kids, the middle class didn’t get it. But, if you wanted a few million in spare change to invest in a business opportunity, buy a new car, build a new mansion, or whatever, it did accomplish such a mission. And that does impact the working class positively. Unfortunately, there is some truth to lining the pockets of the rich does have a flow through effect and gets them to spend money they may not have otherwise.
You may disagree with it and it may not pay for itself but it is stimulative regardless of your emotional response.
“While the tax cuts weren’t directed at the middle to lower income people, there is a very valid argument to be made that jobs are created by those with a disproportionate amount of assets.”
And I can water my garden by setting it on fire and calling the fire department.
I agree with Douglas. There are some big question marks about what the rich did with the $. How much did they invest in emerging markets, China, India, etc? In contrast, all the easy credit increased our consumption, which directly created jobs.
Maybe the tax cuts helped a bit, but it was horribly inefficient, with effects also helping emerging markets, and adding to inequality in the US.
With record business profits and corporate cash holdings, corporate tax cuts are not stimulative. Businesses are choosing to not invest money. There is no shortage of money for them to do productive things with, so giving them more will change nothing.
Tax cuts do not lead to an increase in investments. Every dollar that the government spends has to come from somewhere. It is either collected in taxes or borrowed. Cutting taxes without cutting spending is equivalent to mailing out US treasuries without asking for payment. The net effect on non-treasury investments is 0. Many of the people who get the tax cuts will not buy treasuries, but the increased supply of treasuries will lead to higher rates unless some people sell stocks and buy bonds. Tax cuts cannot increase savings or investment. Only spending cuts can do that. You can argue either way about whether government spending is stimulative or not.
Cutting taxes without cutting spending is equivalent to mailing out US treasuries without asking for payment.
true.
‘Tax cuts do not lead to an increase in investments. ‘
This is completely false. Decades of empirical data prove you wrong.
‘Every dollar that the government spends has to come from somewhere.’
Yes, but other people invest, not just the Feds.
There would have to be a mass socio-economic change for the real estate market to disappear.
Francisco Barcenas