I Love the Smell of Repos in the Morning . . .

Last night, I asked the assembled multitudes what was the Fed’s motivation behind their big 50 bp whack. 

Let me add some spin to the question: OFHEO will now allow Fannie Mae and Freddie Mac to increase their portfolios by 2%/year above cap. 

"In another sign of an administration shift, the regulator for Fannie Mae and Freddie Mac, the Office of Federal Housing Enterprise Oversight, agreed to relax restrictions on the mortgage-finance companies’ investment holdings. Ofheo’s new policy allows Fannie Mae to increase its portfolio by 2% a year, a level comparable with an existing limit on rival Freddie Mac.

Fannie Mae called on the regulator to allow bigger increases. "We still believe the more effective response, given the extent of the market disruption, would be to raise our portfolio cap by at least 10%," Fannie Mae spokesman Brian Faith said."

The details will come out over the next few weeks — but there are expectations this will eventually include Jumbo Mortgages, Sub-Primes, etc.

Thus, a GSE, originally established to make purchasing homes more affordable for the middle and lower classes, has now become a subsidy for speculators and the purchases of McMansions.

These are your tax dollars at work . . .

In a recent letter to Rep. Barney Frank, FOMC Chair Bernanke opposes the increase. We must assume Helicopter Ben does not want competition for their "Credit From Above" air cavalry unit (via a bastardized version of “Apocalypse Now” and Lt. Col. Kilgore’s ‘Death From Above’ moniker for his helicopter/air cav unit).

And, as Bill King notes, we cannot answer the question of whether the Fed plays “Ride of the Valkyries” before injecting credit or cutting rates. But he is hard at work spreading the rumor that Ben ‘loves the smell of repos in the morning.’  He says, “It smells like…victory.”

Less sarcastically, and more specifically, King observes:

"You know all that crappy paper, particularly mortgage-related, that is circumnavigating the universe in search of a home? Ironically, Helicopter Ben might have just made it harder to unload the crap on patsies.

The intent of the 50bp rate cut is to:

1) alleviate the urgency to unload crappy paper, and

2) to prevent a  panic and Northern Rock-like run on US financial institutions. 

Unintended consequences of the 50bp rate cut include:

1) re-popularizing ARMs, especially with so many pundits forecasting more rate cuts. (Isn’t ARM excess a major factor in the current mess?) 

2) Long rates have increased smartly.

Helicopter Ben’s dual rate cuts have cut the legs off of bonds and the non-ARM mortgage market.  Higher long-term yields will force the price of crappy paper lower.  Ben better hope that his scheme to lower the ‘cost to carry’ on crappy paper mitigates the urge to avoid capital losses.

We need some context to comprehend this: Alan Greenspan’s 1% rates created what looked like a huge Housing boom. But what it really created was a credit boom, which then in turn led to a derivative boom and ultimately structured finance boom.

Thus, the so-called sub-prime crisis was merely the match that ignited a much wider breakdown.

I like this quote from Christopher Wood, chief strategist at the broker CLSA:

“This is not a sub-prime crisis. Sub-prime has merely exposed the bigger scam of structured finance; a scam that is about pretending that bad credit is good credit.”

That’s as good an explanation as any of the others that have has been proferred so far . . .



Source:
Credit Markets Show Revival After Rate Cut

DAMIAN PALETTA and SERENA NG
WSJ, September 20, 2007; Page A1
http://online.wsj.com/article/SB119021077354432327.html

Chief strategist at CLSA predicts record gold run
Leo Lewis in Hong Kong
Times online, September 19, 2007
http://business.timesonline.co.uk/tol/business/industry_sectors/natural_resources/article2485085.ece   

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  1. SINGER commented on Sep 20

    Barr… Good Luck w/ all of the projects!!!!

    It’s not a subprime crisis at heart, Wood is right…

    When U.S. rates are a 1% and Japan’s are 0% — and people in the industry will make huge money brokering these loans and creating and selling the structured finance instruments… Then participants could hardly resist moving around that cheap money as many times as possible for as many Bps in fees as possible.

    The subprime blowup merely illustrates the fact that when when the “powers that be” act irresponsibly — the financial system follows suit…

    If the FED etc. wouldn’t eat a big recession after 9/11 but instead put rates to 1% — then that’s a sign to particpants that however risky and unrealistic their borrowing and trading activity may be it would be worth it because there would always be a “bailout” light at the end of the tunnel…

    remember that water will flow with gravity from the high ground to the low…seeping downward as it trickles along…so too with the MASSIVE liquidity injections in the past decade…Eventually in 2004-2005, at the end of the boom, even the most base levels of the system… subprime mortgages were severely beset with irresponsible lending buying selling and borrowing.

    Just a thought…..

    Is the fact that the FED cut 1/2 a point with the INDICES (not nazz) so close to new highs an inadvertant reveal that those highs are only nominally existant and that in REALITY i.e. vs. Gold and other currencies and assets, the INDICES are really down 50% ish since 2001?????

    Any insights????

  2. Ross commented on Sep 20

    Singer is absolutely correct. I got into this business in 1968 when all the major wire houses were gearing up for twenty million share days. The markets double topped around 1971 and flittered between 750 and 1000 for the next 11 years. That was after the 45% drubbing in ’74. Dow theory ‘expert’ Richard Russell opines that he ‘called’ the bottom in ’74. But it did no good. INFLATION over those next 8 years reduced a dollar’s worth of Dow to 35 cents. ALL values and price levels for indexes must be adjusted for the depreciation of your currency. In 20 years I expect a third of all households to have $1,000,000 in net worth. And your latte will cost you $45.
    Von Hyeck (sp) is an economist to be read. Especially ‘The Road To Serfdom”. Pretty clear explanation of current events in my opinion. Save yourself. Buy a farm.

  3. coveredwagon commented on Sep 20

    Excellent post over at suddendebt.blogspot – very compelling idea that the cost of money had to be brought down to save the banks from money market woes – 25 bips was not enough and he posts a graph to prove the point. I think he nailed it.

  4. Greg0658 commented on Sep 20

    yesterday was hearing comparisons of these housing problem days to the farm crisis of late 70s early 80’s

    any true #s on the transfer of family farms to corporate farms? any figures on transfer to foreign entities?

    dont hear much on those new hedge instruments of regional housing prices? how they doing MSM?

  5. Royce commented on Sep 20

    What gets me about the current response is that while people agree that there was a lot of excess in the credit markets, the solution now seems to be to try to reinflate the balloon rather than to ensure there is an orderly deflation.

  6. Winston Munn commented on Sep 20

    Which Fed governor woke up Wednesday morning with “an offer he couldn’t refuse” lying in bed next to him?

  7. SPECTRE of Deflation commented on Sep 20

    For some reason I smell the American Dollar burning this morning. I think Benny missed the mark and dropped the cash on a wildfire. $78.69 is only the beginning of the fall in the current but soon to be former reserve currency.

    The assclowns killed the goose that used to lay the golden eggs. Now it just shits like a goose!

  8. bucky katt commented on Sep 20

    Ross, I agree, and own 3 farms.

  9. Michael M commented on Sep 20

    Bernanke Straddle

    While everybody seems to agree that the 50 bps cut was just the beginning, which it probably is, I think one could also look at it differently. Had the Fed only cut 25 bps there was no way they could take that back in a few months. Such a small cut would have to be followed up not to look silly/meaningless. However, with a 50 bps cut the Fed can come out in a few months and say “we cut to unfreeze credit markets, it worked [for a while], so with credit markets now functioning orderly and inflation risk increasing we keep rates on hold (maybe even increase the discount window rate a bit to look like they mean it)”.

    Cutting 50 bps instead of 25 bps gave the Fed more options going forward, though I doubt they will use them in a Volckerish way.

  10. Donaldo commented on Sep 20

    Looks like now we’ll have a “Reverse Conundrum”. As fed funds rate go down, the yield on the 10 yr treasury note keeps rising.

  11. karl smith commented on Sep 20

    To answer the question running through both of these posts: What was Ben thinking?

    1) Ben believes, as do I, that monetary policy acts largely through its effect on credit. Old school monetarists like Friedman and Lucas act as if more money just turns into more Aggregate Demand. If you print it, they will spend.

    The problem is that the data doesn’t bear that out. The effect of money on the economy seems to act through its effect on credit constraints. More money means looser lending.

    Why is this important? Because a credit crunch acts like a decrease in the money supply. When the 90-day, the Funds Rate and Libor become unhinged, what looked neutral policy can become restrictive policy.

    This is the situation we were facing. The potential that the credit crunch would make monetary policy, effectively tighter.

    My thoughts at the time were that 50 bps are what we need, just to stay neutral. We will see how that evolves from here.

    2) The possibility of a bone crushing recession was very real. The Fed’s change in stance makes a serious recession much less likely. This is not something to take lightly. The debt deflation in Japan after their real estate boom was a big reason Japan entered a major depression.

    A similar event in the United States would be catastrophic. Not only would the US economy sour but it could easily spread into a global recession that would be much harder to cure. That possibility had to be avoided at all costs.

    3) The expectations augmented Phillips Curve is still a good model. That is, just as money doesn’t magically make spending, money doesn’t magically create inflation. There is a channel and that channel goes right through credit.

    For those obsessed with MV = PY, note that credit conditions result in a effective decrease of V. You can think of it as a flight to quality or hoarding dollars if that makes more sense to you. However, the point is declining credit conditions decrease inflation pressures.

    All of this comes together to say that an economy already headed towards soft growth was seriously threatened by a global freeze in credit. This is a serious situation that needs to be taken seriously.

    As long as the Fed is committed to long run price stability inflation can be handled. Expectations of inflation through the TIPs spread have remained moderate and I am convinced of the Feds underlying bias towards controlling inflation.

    However, a very hard landing was in the cards and it is the Feds imperative to stop it. Memories outside the Ivory Tower are short but at heart the Fed is rightfully more concerned about repeating the Great Depression than the Great Inflation.

  12. Pool Shark commented on Sep 20

    Within the next few days the tables will be turned, and the Canadians will be joking about the US$ being worth only a few Canadian pennies.

    Canadian Dollar now at .9985 and climbing…

  13. Bif of glasgow commented on Sep 20

    How about this runaway bull market. is this a truly awesome time that we live or what? Lovin it.

  14. Justin commented on Sep 20

    Good heady stuff guys; thanks for the econ macro 540 refresher. Karl, do you really think that the fed has turned things around? My guess is that the horse is already out of the barn.

  15. a guy called john commented on Sep 20

    karl,
    i’m a newb when it comes to a statement like this:

    “When the 90-day, the Funds Rate and Libor become unhinged, what looked neutral policy can become restrictive policy.”

    I keep running across this connection but still don’t grasp it. Is there an easy overview (link or otherwise) you can provide?

  16. PeterR commented on Sep 20

    PS — Markman article is scary stuff alright.

  17. Chris commented on Sep 20

    What happened? A few months ago, “world was awash in liquidity”. Then suddenly, there was no liquidity. Now, with indexes within about 2tenths of a percent of all-time highs (just an interesting way to look at it–300/14000=.02), everybody’s positive again. The No Pain Society! The We Love Hedge Funds Fed!

    FNMA/FHLMC are a huge part of the problem. Talk about using a drink to cure a hangover. Increasing caps is like switching to beer from the hard stuff.

    This is scary and bleak stuff. Maybe I’m wrong. Not too long ago I sold my house at a price I could not have afforded to purchase with my income which had increased decently since I bought it. Lower rates won’t change that. The housing market has been out of kilter for a long time.

    One more thing, what about guns and butter? Everybody says Iraq as % of GDP not that much, but how can we sustain this spending?

    I think Ben was concerned about FNMA/FHLMC as part of his motivation, and increasing caps is fuel to the simmering fire, but keeps it simmering for a little longer before raging.

  18. Chris commented on Sep 20

    I meant 2% . sorry

  19. rex commented on Sep 20

    Fannie and Freddie is not “your tax dollars at work.”

  20. wnsrfr commented on Sep 20

    Hey, easy U.S. economy fix:

    If you purchase a home worth at least $300K with at least a $200K down-payment, you can have an instant green card, regardless of nationality.

    No known terrorists, though.

  21. karl smith commented on Sep 20

    Karl, do you really think that the fed has turned things around? My guess is that the horse is already out of the barn.

    One can’t be sure at this point. What I do think is important is that the Fed is changing its stance and seems prepared to take whatever means necessary to prevent wide spread debt-deflation.

    “When the 90-day, the Funds Rate and Libor become unhinged, what looked neutral policy can become restrictive policy.”

    I keep running across this connection but still don’t grasp it. Is there an easy overview (link or otherwise) you can provide?

    The 90 day, the funds rate and the Libor all represent the lowest risk interest rates out there. Consequently they usually move together.

    Now, the 90 day is of course what it costs the US Treasury to borrow. The funds rate is what it costs US regulated banks to borrow. The Libor is what it costs international unregulated banks to borrow dollars.

    If the 90 day drops far below the funds rate and the Libor rises far above it, this implies that unregulated banks have become nervous about lending to one another and are instead sticking their money in T-bills. If credit doesn’t flow easily between banks then banks cannot safely lend.

    This is effectively shrinks the amount of money in circulation and leads to either rising consumer rates, stiffening of consumer lending standards or both.

    That exactly what you would expect from an increase in the funds rate. But instead of happening because of a shortage in fed funds, its happening because of uncertainty about the solvency of unregulated banks.

    Therefore, the funds rate has to be lowered even further to get the same effect.

    Now lowering the funds rate doesn’t mean that all the insolvent banks become solvent. It means that the baseline cost of funds plus the risk premium associated with bank insolvency comes out to give you the same interest rate that you wanted before the solvency scare.

  22. tk commented on Sep 20

    Ben Bernanke to Wall St: ‘I am your bitch.’

  23. Globalized commented on Sep 20

    He may be Wall Street’s bitch but Ron Paul tore him a new one today.

  24. SoNotintheKnow commented on Sep 20

    Last night on Kudlow and Company, according to Jim LaCamp, the bankruptcy laws must be change to allow the refinancing of the “underwater mortgages” to stop the bloodletting on the homeowner.

    BTW, Barry, really enjoy your spots on Kudlow..and would appreciate your wisdom on adjusting the bankruptcy laws to stop the massive foreclosures that are coming down the pike.

  25. TheGuru commented on Sep 20

    You CANNOT stop the foreclosures for those people who purcahsed a home they clearly could not afford.

    It’s akin to walking in to a 5-star restaurant with a $20 bill, eating the finest meal they serve and then being in utter shock when the bill comes and you are not wealthy enough to pay it. The guy at the next table is not going to pick up the cost of the meal nor should the guy next door pick up the cost of his neighbor’s home.

  26. SoNotintheKnow commented on Sep 20

    To theguru

    From what I have read the debt is not forgiven just refinanced with an extended allowance to pay back over a 5 year period. Allow me to post a link to the best explanation I have seen on this.

    http://www.smartmoney.com/theproshop/index.cfm?story=20070823&src=fb&nav=RSS20

    from the article:

    That doesn’t work so well when your monthly payment has been bumped up because of an adjustable rate mortgage. That’s the problem suddenly facing a lot of people. It doesn’t work if you can’t even afford the monthly payment. Our proposal is to take the ARMs and re-amortize them over 30 years as a fixed rate. They’d do that as part of Chapter 13 bankruptcy. [This would apply] if your house was overappraised or it’s fallen in value. Say you got a 100% mortgage for your $200,000 house, and now it’s worth $170,000. You re-amortize it over 30 years and pay off the mortgage that way. That’s the crux of our proposal — strip down the mortgage to the current value of the house and re-amortize that over 30 years. We’re hoping that will be introduced in Congress in September.

    SM: Is that considered at least a partial loan forgiveness?

    HS: No, definitely not. It’s been done for years with cars. In 1978 [when the law was first established] we didn’t have these kinds of mortgages either. Even if it made sense in 1978, it doesn’t make sense now.

  27. SoNotintheKnow commented on Sep 20

    To theguru

    From what I have read the debt is not forgiven just refinanced with an extended allowance to pay back over a 5 year period. Allow me to post a link to the best explanation I have seen on this.

    http://www.smartmoney.com/theproshop/index.cfm?story=20070823&src=fb&nav=RSS20

    from the article:

    That doesn’t work so well when your monthly payment has been bumped up because of an adjustable rate mortgage. That’s the problem suddenly facing a lot of people. It doesn’t work if you can’t even afford the monthly payment. Our proposal is to take the ARMs and re-amortize them over 30 years as a fixed rate. They’d do that as part of Chapter 13 bankruptcy. [This would apply] if your house was overappraised or it’s fallen in value. Say you got a 100% mortgage for your $200,000 house, and now it’s worth $170,000. You re-amortize it over 30 years and pay off the mortgage that way. That’s the crux of our proposal — strip down the mortgage to the current value of the house and re-amortize that over 30 years. We’re hoping that will be introduced in Congress in September.

    SM: Is that considered at least a partial loan forgiveness?

    HS: No, definitely not. It’s been done for years with cars. In 1978 [when the law was first established] we didn’t have these kinds of mortgages either. Even if it made sense in 1978, it doesn’t make sense now.

  28. Eclectic commented on Sep 20

    Karl,

    Excellent rebuttal, but you didn’t provide any metrics we might use to evaluate the effectiveness of the recent FOMC actions. In almost every way a reasonable observer might conclude, metrics are showing the action to have been reckless folly:

    http://www.cnbc.com/id/15839203/site/14081545/

    http://www.cnbc.com/id/15839171/site/14081545/

    The Saudis are threatening to de-link from the dollar… and thus potentially begin to price oil in euros.

    I’ll “quote you a couple of times” and ***make my own comments.

    “Ben believes, as do I, that monetary policy acts largely through its effect on credit.”

    *** In fact the actions are causing further tightening of credit via the inflationary expectations that the actions have induced. It’s the deus ex machina that Mr. Mishkin eschews, coming back to bite him in the gluteus maximus.

    “The possibility of a bone crushing recession was very real.”

    ***For the life of me I can’t get a decent bone crusher out to my house… nor can I get a roofer, electrician or plumber without long waits. I drive home by some big boxes and 2 malls that have their parking lots full… There’s a railroad between home and work… Used to never be held up by a freight train for more than a couple of minutes by a passing freight. Now, almost every freight train blocks the road for long periods. The bone crusher is spittin’ out whoppingly scary unemployment so far. Why, this week’s fall-off in claims is positively horrifying. They must’ve gotten new jobs with a bone crusher firm somewhere.

    No, no Karl… Bernanke’s dedicated his whole life to being fearful of depressions. He’s got a trigger finger that’s too itchy and too ready to save us all from economic collapse.

  29. Karl Smith commented on Sep 20

    Eclectic:

    Normalization of the yeild curve is not a bad sign. In fact, it is an indication that the flight t quality is easing.

    The real signal will be if we get a reduction in Libor and the Libor spread. Both and I will say that the intervention worked

    I’ll grant that the dollar is sliding and inducing run-ups in commodities. I don’t have a problem with that, the dollar has been cronically too high. My take is that an inflated dollar is a major driver of income inequality in the US.

    It makes finacing cheap but it makes manufacturing expensive. Moreover, I can’t see how the current account deficit unwinds without a falling dollar.

    It is something that needs to happen.

    As for the bone crusher. Cute story but the history of debt deflation is an ugly one. The point is not that we were probably going to have a rough recession but that we could. Even a 5% chance of Japan-like recession is too much to risk. If the US were to enter such a recession the global economy would almost certainly go with it.

  30. Winston Munn commented on Sep 20

    Eclectic:

    “Exotic new asset-backed securities were so obtuse and opaque that investors couldn’t accurately gauge their risks, Federal Reserve chairman Ben Bernanke told Congress. As a result, ‘global financial losses have far exceeded even the most pessimistic estimates of the credit losses on these loans.’

    ‘The shift in risk attitudes combined with greater credit risk and uncertainty about how to value those risks has created significant market stress,’ the Fed chief said in a written statement prepared for the House Financial Services Committee.”

    Your honor, I rest my case.

  31. TheGuru commented on Sep 20

    sonotintheknow,

    There is a forgiveness of debt element in there (loan would go from $200 to $170) — what happens to the $30 — is it forgiven without tax consequence? If so, that also qualifies as a bailout. Let these people be foreclosed on — the market will recover in a generation. People learn from their failures — there failure are not my problem.

  32. Winston Munn commented on Sep 20

    Your Honor, we recall Minyan Pete as rebuttal witness:

    “I hope you can see by this example why the financial services community is so fixated on Federal Reserve interest rate cuts. By dropping short term interest rates, the Federal Reserve helps to offset the impact of higher borrowing spreads and loan losses. The difference between and a 25 and 50 basis point cut may not feel like much to you, but when all you’re earning at best is 1-2% on assets, it is a huge deal.”

    Offset higher borrowing spreads and loan losses – ABCP off-balance sheet.

    The state rests.

  33. Eclectic commented on Sep 20

    Karl,

    Okay Karl, you’ve acquitted yourself well. I fully realize the magnitude of a potential risk. I’ve been writing about it here for weeks.

    However, something had better change pretty soon, because almost every market metric having a present or potential detrimental effect on the economy is currently pointing a finger of cause at the FOMC action. A few of those commentators otherwise friendly to the Bernanke FOMC have been expressing doubts, even some Kudlowvians.

    The Fed is not supposed to induce volatility in markets.

    I rest my case, Your Honor. I expect the jury will be out for another day or two. Maybe a verdict can be reached by Monday. A fortnight will give members of the jury in Asia and Europe a quiet weekend to ponder what it all means. They’ll start speaking to us along about Sunday night, late evening, E.S.T.

    http://www.cnbc.com/id/15839171/site/14081545/
    http://finance.yahoo.com/q/bc?s=%5ETNX&t=5d
    http://finance.yahoo.com/q/bc?s=USDEUR=X&t=5d

  34. John commented on Sep 30

    Hi, nice blog. Pretty informative. But,before you start signing papers with a broker, it is important to discuss fees. Brokers work on a commission basis and often receive lender fees. The broker is usually paid by the buyer or lender. You can pay the broker with cash, rebates, or proceeds from your loan. The fees are added to your total amount.

    thanks, john http://www.thejohnbeck.tv

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