The wellspring of market patience and confidence is drying up amidst signs of continuing leadership ineptitude and political expediency. There is no bold plan that impels the market or the public to confidence in an early economic or financial turnaround. As a consequence, there will be a continuing tale of economic and financial woe.
Expect the credit crunch to persist, bank and other bankruptcies to continue proliferating, the recession to deepen through this year into next, for official unemployment rates to continue rising into double digits, with real unofficial unemployments rates to reach even higher levels, outright deflation to take hold and equity prices to decline further. US Housing prices, at the heart of the US and global financial and economic meltdown, are likely to drop significantly further, perhaps by an additional 15% to even 20% nationwide. This is despite the welcome but too narrow and very temporary halt to forclosures announced by Fannie Mae, Freddie Mac, Chase and Citibank. As well meaning as the Federal government's efforts are, they are too little, too late. too disjointed, too mis-directed, and too ill-concived. The stimulus and bailout efforts continue to primarily target only the consequences or symptoms, not the root cause of the global economic and financial meltdown. Too much of the so called stimulus spending will have its primary impact next year. And much of it will be used to pay down debt or merely as a substitute for lost revenue, whether for individuals, business or state and local governments. That ammounts to palliative care.
In 1932, President Franklin Delano Roosevelt said "These unhappy times call for the building of plans...that build from the bottom up and not from the top down, that put their faith once more in the forgotten man at the bottom of the economic pyrimid". That focus on the bottom for the current problem implies a focus on the borrowers of sub-prime mortages and other mortgages in distress. Relieving that distress would go far to quickly arrest the financial problems underlying the mortgage-related paper debacle and the threatened bankruptcy of the financial system.
A variation of a plan proposed by Barron's would go a long way towards accomplishing the desired objective. Barron's proposes injecting $200 billion in "TARP" money in exchange for a 25% reduction in the mortgage principal owed on sub-prime mortgage loans. I would go much further. I would count the funds already invested by TARP as a down payment on that remedial objective. And I would extend the partial mortgage principal forgiveness approach to Alt-A mortgage loans as well.
At least a one-year moritorium on foreclosure for homeowner occupied homes would reduce or arrest the downward pressure on home prices. Abuses to the system by those able to pay their mortgage but choose not would be a price worth paying to stop the downward spiral in home prices fed by the forced bank sales of forclosed properties. Those homes that have already been foreclosed should be offered back to the prior homeowner on subsidezed rentals that allow for eventual repurchse on favorable terms. Banks should not be required, as they are currently, to quickly sell the foreclosed homes. That only forces them to typically take steep loss charge-offs against their capital. Instead, the banks should be permitted to hold the properties on their books without chargeoffs, particularly if they are offered to former resident owners on favorable terms.
There should be a mixed Federal-private program to buy up unoccupied homes and rent them to potential resident home-owners at attractive terms. That would limit or arrest the decline in home prices, attract speculative buyers and help end housing distress.
It would also be appropriate to put in place at least a temporary reprieve on the mark-to-market accounting requirement which forces banks to write down the asset value of mortgage loans and other assets even when there is no sale of the asset, no realistic market price, and not even a delinquency or default on the loan. When there is such a write-down of the asset, the financial institution is required to charge the unrealized loss against capital. These phantom losses can even force the institution into bankruptcy. It is senseless to maintain this requirement even in this emergency period.
There is a wider yield spread between the reduced Fed charge for funds to banks and the onerous mortgage rates being charged on some mortgages by those banks to homeowners in distress. That wider yield spread translates into profits for banks that should be passed by the banks back to the homeowner in the form of lower mortgage rates on existing or refinanced mortgages. It can be argued that the financial crisis is a result of predatory lending, collusion, fraud, stupidity,irresponsibility or at the very least morally reprhensible greed on the part of lenders, mortgage brokers, appraisers, investment bankers, the rating agencies and borowers. That trumps the supposed sanctity of mortgage contracts, especialy when maintaing that sanctity could bankrupt the financial sysytem.
Instead of such common sense proposals there is profound disappointment with both the lack of specifics in Treasury Secretary Geithner's bank bailout plan, the long delay in formulating a consistent and workable solution and the unfocused mere spending aspects of the Federal stimulus package, That disappointment this week led to a continuing selloff in the equity market, especially financials, and a weak sale of the Treasury new 30-year bond last Thursday. Conversely, the lack of confidence that the government's initiaties will be effective without producing either inflation or deflation was a spur to gold prices, which are making a new run on the $1,000 plus previous high.
The equity market was down particularly sharply. For the week, financial stocks were down as much as 10%, while the Dow industrials were down 5%. Indeed, at 7,850 at Friday's close, the Dow industrials were only 4% above last November's low and apparently heading for at least a retest of those lows or more likely new lows. This negative equity market performance, though realistic given the economy's profound weakness, is all the more surprisingly given the market's tendency to at least temporarily turn euphoric with a new President and a new set of stimulative initiatives. Instead, the equity market remains clearly defensive, with health care one of the few sectors trading at or above its 200 day moving average. Some analysts believe that until this defensive sector turns negative, the potential for the rest of the market to rally on a sustained basis is limited.
The new Treasury 30-year bond was auctioned Thursday at a yield of 3.54%, only to sell off to a yield of 3.69% on Friday. (The higher market yields on the 30-year Treasury bond translated into a a more than 4 point drop in its market price.) The yield will decline as the new issues move into stonger hands. Nevertheless, the Treasury market seems caught in a see-saw balance between conflicting concerns and market forces.
Helping to keep safe-haven purchases of Treasuries in place are concerns that the stimulus package and other Federal initiatives may not be either large enough or sufficiently effective to keep the recession from deepening. Indeed, the realty of the deepening recession is keeping the fear of outright deflation alive, a positive for higher Treasury prices and low Treasury bond yields. Also supporting the Treasury market are foreign purchases and the threat of Fed purchases of longer-term Treasuries to help bring down mortgage rates, which are often determined by the yield spread from Treasury yields. In the past, the rule of thumb has been that high-grade 30-year corporate bonds (when there is little or no risk of default) would yield some 1 percentage point above 30-year Treasury bonds. And 30-year mortgages would normally yield some 2 percentage points above 30-year Treasury bonds. Thus, given those historical relationships, there is an incentive for the Fed to buy Treasury bonds as an almost promised means of better achieving its broader mortgage market objectives. However, there appears to be some recent back-pedeling on this issue considering Fed Chairman Bernanke's comment that there is some disagreement on the Federal Reserve Board on this issue of Fed purchases of Treasury bonds.
Other forces are driving Treasury bond yields higher. The Treasury market fears the size of the budget will swamp buying demand both here and abroad for Treasuries. Buying demand overseas will be reduced as their trade surpluses wane and the need to stimulate their domestic economies forces a diversion of new funds away from purchases of Treasuries. The realty is that most Treasury financing is short term, where Federal Reserve buying can readily augment or replace domestic or foreign buying. Less predictable is the potential of ever more sizable shorting of Treasuries to finance the purchase of corporate bonds, especially high-yield junk bonds, where the yield spread is exceptionally attractive. Of course, the yield spread between Treasuries and junk bonds is exceptionally wide for a good reason. The risk of default in that sector is exceptionally high. It remains to be seen if the incidence of loss through bankruptcy is as moderate as 16% as some investors anticipate. The speculative buying of junk bonds also reflects a shift of investment from other sources, such as money funds. Regardless of the source of the investment in junk bonds, the buying has already contributed to a narrowing in the quality yield spreads from Treasuries to junk bonds, as well as to high grade corporates, a far more prudent investment in the current enviornment.
Some odds and ends. Last week GE injected substantial funds in GE capital in the hopes of maintaining their AAA rating. Thus far, that only helped the yield on its longer dated bonds edge down from 8.0% to 7.9%. However, a further substantial decline in this yield is inevitable as the excessive GE default risk priced into its bond yield subsides and Treasury yields stay low for an extended period.
Philip Braverman, President
Braverman Economic and Financial Consulting
One Hewitt Square #249
East Northport, New York 11731
Email address: philipbraverman@Gmail.com
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