Rising Mortgage Rates: A Bailout Side Effect?

The average 30-year mortgage rate jumped to 6.46%, up from 5.94% a week ago. The last time we saw a spike like this was 1987. Higher mortgage rates means even fewer people will be buying houses, vacant home prices will fall, and owned-home values will decline. This also means the value of all those bank-owned, mortgage-exposed securities (the cause of the credit freeze) just ticked down. That makes me nervous. Let’s talk about how this happened. But first…

Intro to Bonds
There is a wide variety of bonds out there. For our purposes, we’ll talk about the three hugest bond categories, listed in order of riskiness:
1)Government bonds: These include T-bills (Treasury bills), T-notes, and T-bonds. When you buy these, you’re lending money to the government. These things are guaranteed by the government. If the government is short of cash, the Treasury will print you up brand new cash. No risk means low rate of return for investors.
2)Fannie/Freddie bonds: Fannie Mae and Freddie Mac were set up by the government (i.e. they’re government sponsored entities, or GSEs) to help move mortgages and make them cheaper, because homeownership was thought to be good for America. Because the government has a hand in these organizations, GSE bonds are considered less risky than corporate bonds. But, they’re not explicitly guaranteed by the government. As such, GSE bonds have moderate risk and offer a moderate rate of return for investors.
3)Corporate bonds: Companies, including banks, issue these to raise money. But companies are allowed to go bankrupt. This higher level of risk means a higher rate of return.

Lehman Brothers was a company that went bankrupt. That sucked. A lot of people, including other banks, were holding Lehman bonds. A ton of people had CDS exposure to those bonds. A bunch of institutions still have accounts at Lehman that are currently frozen. And ultimately, it destroyed confidence between banks. It is not good for a bank to go bankrupt.

Uncle Sam’s $250 Billion Bet on Banks
On Tuesday, behind closed doors, the Treasury, the Federal Reserve, and the FDIC basically forced a couple big banks (including Citigroup, JPM Chase, and Bank of America) to accept a government investment. In return, America would get ownership stakes in the banks and a 5% annual return. There were other terms to the deal, but that’s not important to this discussion. Ultimately the banks were borrowing money cheaply and, assuming those banks don’t go belly up, the taxpayers would earn a decent rate of return.

Bank Bonds Suddenly Look Sweet
Now that the government has a hand in these banks…maybe they won’t be allowed to go bankrupt. Very quickly, the risk level of these banks’ bonds fell. In fact, bond market action suggested the bank bond risk was similar to GSE bond risk. In other words, banks bonds' risk now reflected that of the second category of bonds we spoke of. But bank bonds offer a higher rate of return than GSE bonds. So why buy GSE bonds?

The Effect on and of Fannie/Freddie Bonds
In order to compete with bank bonds, GSE bonds have to offer a higher rate of return. In order for GSE bonds to offer a higher return rate, mortgage rates have to go up. The dynamics of this relationship are complicated, and I’ll explain in a future post. I suspect we’ll hear more about Fannie Mae and Freddie Mac in the near future. That might be a more appropriate time to explain how the GSEs operate.

The Big Picture
So, did the Treasury consider the bank bailout’s effect on mortgage rates? Gosh I hope so. Regardless, no plan was going to be perfect. Especially a plan that had to be rushed. I think this mortgage rate spike might just be a side effect, sort of like a mild fever after a vaccine. Remember, the primary goal of the bailout plan was to unfreeze credit in an effort to prevent Great Depression 2. I believe that Great Depression 2 would be much, much worse than any effects of the mortgage rate spike we’re seeing now.

Importance of Economic Indicators

It’s the third or fourth day of unfreezing in the credit markets, as reflected by lower interbank lending rates (i.e. LIBOR rates) and declining short term corporate borrowing rates (i.e. commercial paper yields). But those rates are still high and the thaw is coming at a painfully slow rate. Good companies are still having a tough time paying bills while running their businesses. Regardless, the global flood of government-backed money into banks has at least changed the direction of the credit crisis. Let’s hope it stays that way. We’ll keep an eye on this. Our other eye can now refocus on the big picture: the economy as a whole.

From Worse to Bad
Thanks to government intervention, the chances of avoiding Great Depression 2 have improved. Eventually, we may have to worry about inflation, tax, and federal budget implications of all this money flying around. For now, the most important thing is to keep roofs over as many peoples heads as possible and soup kitchen lines as short as possible.

So why the f*** did the Dow plummet 733 points or 8%?!?! Like I said in my Oct. 11 post, even if credit unfreezes, we still need to think about the underlying economy. And today we got the numbers on two key economic indicators: retail sales and the producer price index.

Retail Sales Figure
I've suggested that moving forward, “we won’t be buying as much as we used to.” I’m not qualified to quantify a decline, but my tone was pretty negative. Perhaps I was too bleak, but it turns out the opposite certainly wasn’t true. Today, the Commerce Department told us that September retail sales fell 1.2% month-over-month. That may sound like a small number, but let’s not forget how big the economy is. Let’s put it this way: if normal body temperature of 98.6 degrees rose by 1.2%, you have a slight fever of 99.8 degrees.

Nobody Likes Surprises
So, a 1.2% decline. What idiot wasn’t expecting a decline in retail sales? Well, an important survey of pretty smart economists revealed an expectation for 0.6% decline. That means the actual number was 0.6% (or 60 basis points) worse than the expected number. This is a big margin. What if Obama is ahead in the polls, but come November he loses the election. That would be unexpected, right? Well, when it comes to worse-than-expected economic data…

…the Stock Market Sells Off
Remember, stocks reflect expectations. Most would argue that weaker-than-expected retail sales caused much of today’s 733 point decline. Another chunk of that decline probably reflects a new expectation for worse-than-initially-expected economic data to come. In other words, expectations for the economy are deteriorating. And for those who believe we're in recession, weaker data means a deeper or prolonged recession.

If you can follow this logic, then you’re probably qualified to discuss the day-to-day swings in the stock markets at your next cocktail party.

More Cocktail Party-Talk
The Dow closed at 8,577 today. That’s 1.5% higher than Friday’s closing price of 8,451. Hmm. I might argue that people think America’s economic prospects look better today than they did Friday. But not as good as it did Monday when it closed at 9,387.

Whatever the case, these swings reflect uncertainty. And uncertainty translates to volatility. And there's still a lot of very uncertain data to come.

Look on the Bright Side
The Producer Price Index (an important measure of inflation) fell 0.4%, as expected. Why did they fall? Oil prices are down. At $73 per barrel today, oil is down 50% from its July 11 high of $147. That means all of the oil derivatives just got cheaper. These include gasoline, jet fuel (plane tickets), heating oil, plastic, and all kinds of chemicals. Things are getting cheaper. Enjoy.

One More Thing
Today’s retail sales metric reflects September performance. The Dow opened Oct. 1 at 10,847 and closed Oct. 15 at 8,577, down 21% in 15 days. If you have stocks in you 401k plan, that sucks. October has been a crappy month. At the end of the month, how much do you think retail sales will have fallen?

Financial Crisis in English

Before a few weeks ago, layoffs have been isolated to a few industries (e.g. construction, finance). If you hadn’t been laid off, you were probably taking a hit on your 401k plan, mutual funds, and stock portfolios. More recently, stocks have plummeted. I have a big diverse group of friends working various jobs; in the last two weeks, almost all of them have reported layoffs at their companies. Even seemingly strong companies in healthy industries are laying off people. My job for the last 2.5 years has been to analyze companies and find out what may affect them. My experience is limited, but based on research I’ve done and experts I’ve spoken to, I believe ongoing economic/financial crisis has escalated to a higher order of magnitude and I also believe the media is doing a poor job of explaining what is really going on. This is an extremely complex situation and there's no short explanation. Give me a few minutes, and I’ll explain why things are really f***ed right now and why our future is f***ed.

Credit, the Frozen Credit Markets, and the Alphabet Soup
In the business world, almost every financial transaction involves cash and borrowed money (i.e. credit). This includes buying inventory, paying employees, paying rent, and in many cases paying off borrowed money. If your company has trouble accessing credit, they’ll have trouble meeting these obligations (i.e. not enough goods on shelves, lay offs, eviction, and bankruptcy). Assuming your company is healthy (i.e. strong balance sheet, well-capitalized), at least some customers and some suppliers will having trouble operating because of lack of credit. Everyone from the Gap, to Ford, to Boeing sells stuff to customers on borrowed money. And even Chinese sweatshops operate on borrowed money. If your customers can’t buy stuff and your suppliers are preventing you from selling stuff, you’re going to take a hit. Right now, a sh*tload of people/companies can’t access credit because credit markets have been frozen for a while. And every day credit is frozen, people are getting laid off and companies are going out of business.

Why aren’t banks extending credit (i.e. lending money to people and companies)? Well, banks need that cash right now for at least 4 reasons:
1) Banks own a lot of unsellable (i.e. illiquid) MBSs, CMOs, CDOs and a ton of other securities whose worth is determined by home values, which are plummeting. Because banks have to constantly update the cash values (i.e. mark them to market) of these securities, it looks like banks are losing money.
2) Banks have already lent out a lot of money so that people could buy homes, buy cars, and get college educations. They’ve also already lent money to those companies we just talked about. And now banks are terrified that a lot of those borrowers will not be able pay them back.
3) Banks are afraid that customers and clients will pull their deposits out of the bank (i.e. a run on the bank).
4) The CDS problem: Holy sh*t. Literally, God only knows how big this problem might be. A CDS (or credit default swap) is an insurance policy on a bond. It’s estimated to be a $62,000,000,000,000 unregulated market. Let’s go straight to an analogy. Nick has a car. AIG sells him a car insurance policy. Then I think, “Hmm, I don’t own a car, but I’d like to get money if Nick crashes his car.” AIG is convinced he won’t crash his car, so they are happy to sell me a policy and collect an insurance premium. In fact, they sell a hundred people like me that policy on Nick’s car. Then other people realize how AIG is making money. They start selling insurance policies on Nick’s car. For years, people make and lose money when the chances of a car accident increase and decrease. This process is repeated for other people’s cars. But now Nick totals his car. Suddenly, billions of dollars of cash needs to trade hands on one $30,000 car. It gets worse. Nick’s car accident directly causes the losers in this transaction to crash their own cars. In reality, Nick’s car is Lehman Brothers and that insurance policy is a CDS. All of those other buyers and sellers of CDSs are banks, insurance companies, hedge funds, pension funds, etc. all over the world. What’s worse? They all engaged in these transactions with borrowed money. Nobody knows for sure who owes how much money. CDSs were and are also traded on mortgages and all of the alphabet soup.

Banks make money because they are allowed to take a fraction of customer deposits, lend them out, and collect interest. Regulators require and investors want banks to always keep a fraction of that money on their books. The 4 reasons we discussed make banks’ books shrink. That’s why they won’t lend money. The last time banks were this tight, we ended up in the Great Depression. The business aspect of World War II got us out.

Fear, The Central Banks, and the $700bln Bailout Plan
Central Banks across the globe have been lending trillions of dollars to banks (via rate cuts, TAFs, TSLFs, etc.) so that they have more cash on their books. Central Banks thought this would give banks the confidence to lend money, but instead, banks are hanging on to this money because they’re still afraid of going the way of Bear Stearns, Lehman Bros, and Washington Mutual.

You should also know that banks constantly borrow and lend from each other; this is key to the flow of money. But they’re not lending money to each other either (as reflected by high LIBOR rates). Why? It’s kind of like the banks are not having sex because of fear of STDs. Some banks have different levels of STDs (in the form of MBSs, CDOs, etc.). If bank A lends money to bank B and B dies of an STD, then A will get sick. The cure for these STDs is improving home prices. Central Banks are handing out condoms in the form of federal loans and insurance, but banks are still terrified.

The $700 bln Bailout Plan will buy MBSs, CMOs, CDOs from banks, effectively converting these things to cold hard cash. In theory, the government will buy this for more than nothing (helping banks) and less than they’re really worth (which is great for tax payers). The government will be able to do this because the only non-govt investors willing to buy these won’t pay sh*t for them. And the banks aren’t willing to sell for sh*t prices. Unfortunately, it will take weeks before we know it works.

The Spiraling Problem
Banks lend less, companies default, unemployment rises, individuals default, banks get weaker, banks lend less, companies default, unemployment rises, individuals default, banks get weaker, banks lend less, companies default, unemployment rises, individuals default, banks get weaker, banks lend less, companies default, unemployment rises, individuals default, banks get weaker, banks lend less, companies default, unemployment rises, individuals default, banks get weaker…

What Else Do We Know
On average, economists expected the U.S. would lose 100k nonfarm jobs in September. Last week, we found out that we lost 159k jobs. Year-to-date, U.S. companies have cut 760k jobs. Also, more and more people know something is wrong. They might not understand what’s going on, but they know their 401k plan is evaporating, their friends are getting laid off, and all those people on TV say things are terrible. Remember, 70% of GDP is consumer spending. If consumers spend less, companies make less stuff, companies need fewer employees, and even fewer people are buying stuff. This speeds up that downward spiral.

What if Credit Unfreezes and Businesses and Consumers Are Free to Borrow Again
Let’s assume the government interventions work and credit markets unfreeze completely tomorrow. This would help the spiraling slow and perhaps stabilize. But things won’t go back the good ol’ days that we’ve had in recent years. Banks are currently deleveraging. You see, banks borrowed a sh*tload of money so they could lend a sh*tload of money. After seeing other banks collapse (e.g. Bear Stearns, Lehman Bros, Washington Mutual) and struggle (e.g. Goldman Sachs, Morgan Stanley, Citigroup, Bank of America), banks will lower their borrowing levels and ultimately, they will be lending money at lower levels. Fool me once, shame on you; fool me twice, shame on me. Say goodbye to easy credit. Joe Sixpack won’t be able to buy that pickup truck, that house, or that LCD tv. [This cycle will last a generation. Leaders who live through the current crisis will die, and a new generation will make our mistakes all over again.]

But even if you do have credit, do you think the average consumer is going to borrow like they used to? Millions of people are getting kicked out of their homes. You or someone you know just got laid off. Your 401k plan just went straight to hell. Most of us have less money or we’re scared of not having enough. The President and the government all want us to go back to spending so that the economy gets rolling again. As long as we spend like crazy, people will have jobs, and the politicians will have done their jobs. Maybe we’ll continue to buy sh*t we don’t need, but I think there’s a good chance we won’t be buying as much as we used to. [This cycle will last a generation. Parents who live through the current crisis will die, and a new generation will make our mistakes all over again.]

Conclusion and the Outlook
The recent economy had been built on a foundation of high levels of borrowed and lent money, collateralized by mortgages. Everyone (borrowers and lenders) thought housing prices would increase forever. Americans spent $1.38 for every $1 of income during this period. (Mexicans spend 60 cents and Europeans spend between 85 cents to $1.) Wall Street and home buyers bet trillions of dollars on this idea. Well, they were wrong. And now everyone’s paying for it.

The old economy was built on this bad assumption and no government intervention will change this realization. The new economy won’t make that mistake again. Americans are not as dumb as they look and they will be smarter about their purchases. Unfortunately, this will cause the economy to shrink toward some sort of equilibrium. Millions of jobs will be lost, unemployment will rise, real income will fall, and we will struggle as a nation for years.