Wednesday, September 19, 2007

It's Party Time Thanks to the Fed's Cut

Buckle up, this is a long one.

We were going to rant and rave about the Fed’s action this week as well as get into the long term implications but we have decided to forego all of that in favor of a night off or two. Besides you can read all about it on the internet for yourself.

Did you notice that the CPI fell 0.1% last month according to the report out Wednesday morning? What was glaringly missing was the ever present reference to the "core" inflation rate. Like we have been saying, as soon as the real rate was lower than the "core" rate, they would report the real number. It's such a game.

Anyway, we were fairly convinced that the market had shown us that it wanted to go down starting in July and that wave took us to the August lows. As we watched the market move up from the rate cut news on Tuesday, we are convinced that the Fed was watching the same things we were and that they wanted to stop this train from going any further South.

With that said, the possibility of the Fed being able to prop up the market much more is growing weaker by the minute. We are of the opinion that what is coming from the consumer side is very poor retail sales going into the holidays. Lower short term interest rates either are justified or they are not so if the Fed is justified then is seeing the appropriate items and wants to stem the tide of deflation as soon as possible. Unfortunately, this overly aggressive 50 bps move can only mean that the Fed is scared.

The stock market interpreted the Fed’s statement this week as further rate cuts are coming which is something we believe, too. For the moment, the stock market thinks it’s party time but they don’t realize that the Fed sees some bad things down the road just a little ways. Of course, the only thing the Fed can do is pump money and lower short term rates. At least, that’s all it can do on the surface.

So, we have the Dow now up 11% on the year and the Fed feels that a rate cut is necessary. Does this means that the stock market is not the discounting mechanism it used to be and the Fed is out in front of the market??? We can’t even type those words without wondering if that is even possible. Conclusion is that the Fed is very worried about the effects of deflation and would rather worry about the ramifications of the dollar dropping and inflation coming back because of it. They said as much last week as we have noted here on two occasions.

The Fed must have weighed the risks that the stock market would go up a lot in the aftermath of their 50 bps drop against the bigger evil of deflation coming calling. We still think deflation is stronger than the Fed and will have a powerful (negative) effect as it rolls through the economy. We saw a mini-version of it over the past couple of months in the mortgage market and we think that is just the beginning, with a little timeout to watch some Fed incited stock market gains.

The value of many mortgage backed assets declined rapidly over the last couple of months as losses mounted in some heavily leveraged hedge funds. This caused everyone to look around and say maybe we priced these assets inadequately. So, we ask the question, “Why are these assets going down in value?” Well, that’s because the underlying payments are not coming in like they were supposed to in the agreement. As more and more homeowners start to miss payments on their mortgages or defaults occur, the mortgage holders will not get as much money back as they thought. Then these houses will need to be sold as defaults happen. This causes the real estate market to spiral downward as more and more inventory comes on the market with less and less buyers.

The situation involves many parties but it is very simple:

I own a home that I’ve owned for, say 17 years. I get a call from someone who says I can lower my payments and take some money out of the house for other expenses such as a vacation or a new car/SUV. Plus, the best thing is that my payments don’t have to go up at all with this new fangled option ARM loan. I say, ok, let’s do this thing. Now, my fixed rate mortgage that only had 13 years to go on it is refinanced to go back to 30 years of payments. This does not consider the price appreciation on my house. Let’s say that when I bought my house, I paid about $200K for it and now it is worth, well, $425K. So, my mortgage broker says hey great let’s take out a $425K loan and you can pay off that loan you had left of maybe $125K and you can actually take out an additional $300K.

With that money burning a hole in my pocket, I decide to invest in more real estate since by golly it’s going up right. I get hooked up with a broker down in Florida who says there’s a great deal that I need to take advantage of right away or I will lose it. That doesn’t make me slow down; I want that property before it goes to someone else so offer a little more than they are asking for it. We sure wouldn’t want to miss out on it.

So, I buy the property without actually going to look at it and start making monthly payments on it. I didn’t intend to keep it just to keep it long enough to make a little money on it. Now, the market for that condo I bought across the highway from a graveyard can’t be sold due to there being no buyers for it. Yes, good real estate in good areas is doing ok but I didn’t buy one of those so mine will have to sit on the market for a while, or maybe more.

Then my mortgage company sends me a letter telling me that it’s been 2 years that I’ve had the loan on the condo and that they are now going to reset my mortgage payment to a slightly higher rate. (They said it was one of those 2/28 plans that resets after 2 years.) My payments will only go up about $500 a month. The property tax statement comes in the mail and that too suggests that I might have to kick in a little more in the way of helping the governor. Oh, and by the way, the association fees are going to have to go up a little on the condo because we have a lot of empty units that haven’t sold so we need to do an assessment on the current owners.

Two years ago, I had a nice simple life with only 13 years left on my first mortgage, which would have been only 11 years, now that I think about it. Today, I have a mortgage payment, association fees, and other costs for managing my Florida condo and I have 30 years, ok only 28 years, to go on the mortgage on my residence. What should I do?

Ok, well, certainly this scenario could be adjusted to take other events into account like doing the cash out thing more than a couple of times and maybe buying a few pieces of real estate that actually worked out, but you get the general idea. The people in these types of situations are strapped for cash and holiday shopping will be done on credit cards if they can swing it but we say that they did that last year and this year will be much tougher.

But, multiply this scenario by the many people who did this and you can start to see that a 50 bps drop in the short rates will not help the situation. What will happen is that the condo will most likely be abandoned and the person may actually lose their first residence due to this situation. As you know you read about many people who have defaulted on their mortgages and have lost their homes to foreclosure. This is a major deflationary event by itself. Taken as the millions of times it happens is a catastrophe across Middle America. But, the Fed is there to lower rates and provide liquidity for the investors on Wall Street who made these types of loans available.

This is the definition of moral hazard…and it results in deflation with a capital D.

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