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Wednesday, October 29, 2008

Ben Bernanke Vs. the Housing Market

Yesterday, I got this internal email that does an excellent job of explaining the short term movement of mortgage bonds. (they have exploded up over the last week or so)

The activity in MBS markets - and other financial markets - has been very unusual this month. The Fannie Mae Required Net Yield has already made two round trips from about 5.70% to 6.60% over the past few weeks, displaying a level of volatility rarely seen. Under normal market conditions, the vast majority of the significant rate movements are the result of fresh economic news. This month, however, it has been common to see large rate movements unconnected to any news announcements, for reasons discussed below.

One reason is that the credit crisis has forced many investment funds and financial institutions to reduce their leverage and raise capital. In many cases, these big holders of MBS are selling assets across their portfolios. This explains why MBS, stock, oil, and other markets have frequently all been falling on the same days. The fundamental economic data clearly supports lower mortgage rates. Global economies are slowing, oil prices are down, and expectations for future inflation are moving lower. As long as these investment funds are forced to sell assets, however, there will continue to be upward pressure on mortgage rates. How long it will last is one of the biggest questions facing investors today.

Now, the short term movement of mortgage bonds, and by extension the rate on mortgages, is certainly something that only mortgage professionals care about. That said, the long term movement of mortgage rates is something everyone should be concerned about. What this email essentially says is that the economic crunch has forced major institutions like investment funds to cash out of Mortgage Backed Securities, like those backed by Fannie/Freddie, and turn that into cash. As such, this has caused the price of these bonds to go down and by extension the interest rate on them to go up. (the price and the rate have an inverse relationship) Now, this is all short term and certainly there is a good chance that once this dynamic has ended the rates will come back down.

The fed is once again expected to cut its central rate. The expectation is that the Federal Funds Rate will be cut to 1.00%. That will be only .25% over what it was at the worst of the recession back in 2002. (I have long held this dramatic cut in rates as the catalyst for the eventual mortgage crisis) Now, Bernanke is clearly attempted to provide short term stimulus to stabilize the economy.

Here is the rub. The central rate is a short term rate. It is used for borrowing for short term money, one day, one week, one month, three months. Mortgages are long term, thirty years. Right now, we have no inflation fears. Mortgages don't respond to short term fears but rather long term fears.

Why does all of this matter? Mortgage rates are once again approaching 7%. If Bernanke cuts the central rate, they will likely cross above 7%, at least in the short term. Each and everytime Bernanke has acted to create short term liquidity what that has done is exploded rates upward in the short term as well. They eventually came back down each and everytime however never as much as they came back up.

Now, everyone agrees that our economy isn't going to come out of this rut until housing stabilizes. What are the chances of a stabile housing market if the 30 year fixed mortgage is sitting at over 7%? Most good borrowers are currently holding onto mortgages in the low six's, high fives, and sometimes even lower. The chances that someone is going to sell in order to replace a 5.5% mortgage into a new mortgage of 7.5% is very unlikely.

What we currently have is a Fed drunk on action, and possibly power. In other words, the Fed is addicted to Fed action. Of course, each and every fed action is viewed by the market as inflationary in the long term. It should be. Cutting short term interest rates this low only floods the market with money. That is inflationary. We are already running up troubling deficits and we're about to add $750 billion to that. The Congress wants an immediate stimulus and so we'll add another $150 billion to that. All of these are inflationary in the long term. All of these are bad for mortgage rates. The only opportunity for the housing market to stabilize is for mortgage rates to get low enough to cause good borrowers to act. With rates over 7% it causes borrowers to do the exact opposite. As such, whatever short term stimulus Bernanke provides, it will be at the expense of the long term health of the economy.

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