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If you’re an optimist when it comes to the U.S. economy, the pieces of the puzzle seem to be coming together fast.
Late last week, the Bush Administration unveiled a plan for an interest-rate freeze on certain subprime mortgages that was aimed at containing the downside to the badly stumbling U.S. housing market.
Then the jobs report came in at a “perfect” gain of 94,000 jobs for November – barely beating consensus by being neither too hot nor too cold.
The bottom line: At a time when a wave of foreclosures and tightening credit conditions have raised the risk of recession to such a point that the policymaking Federal Open Market Committee (FOMC) has no choice but to cut interest rates, recent developments have paved the way for the central bank to do so for the third time this year. Central bank policymakers are expected to reduce short-term interest rates by a quarter point when they meet today (Tuesday).
The FOMC already has cut the key Federal Funds Rate twice since mid-September, bringing the benchmark rate from 5.25% to 4.5%. Few analysts have ruled out the possibility of a reduction of half a percentage point, but most believe that a quarter-point cut is more likely.
Mike Moran, chief economist at, told Marketwatch.com that U.S. gross domestic product (GDP) looks like it will advance at a rate of less than 1% for the fourth quarter – a tepid performance at best. Additionally, high-energy prices and tight credit conditions seem likely to constrain the world’s largest economy even into the early part of next year.
Last week, in its quarterly snapshot of the mortgage market, the Mortgage Bankers Association said the percentage of home loans falling into the foreclosure reached a record high in the third quarter. Also, according to the Reuters/University of Michigan preliminary index of consumer sentiment, consumer confidence sank to its lowest level in more than two years during the month of November. Consumer confidence is viewed as a harbinger of future consumer spending, which accounts for as much as 70% of economic activity in the U.S. market.
“Rising prices for fuel and food had a devastating impact on household budgets, and falling home prices have diminished consumers’ sense of financial security,” said Richard Curtin, the director of the Reuters/University of Michigan Surveys of Consumers.
However, the most significant damage seems to have been done to the financial markets, where many commercial banks seem to have reduced – or even halted – lending to one another in order to protect their precious capital.
“If you look at what's been the driver for the Fed the past couple of meetings, it hasn't been as much the economy as it has been what's going on in the financial markets,” Brian Stine, senior portfolio manager with Allegiant Asset Management Co., told CNNMoney.com.
“You could see the Fed drop the Fed Funds rate by 25 basis points and cut the Discount Rate by 50. That would enable banks to borrow at lower rates without affecting the rest of the economy,” Stine added. The Fed Funds Rate determines the overnight rate at which banks lend to each other, whereas the Discount Rate is the rate at which banks borrow money directly from the Fed.
While many analysts believe there’s a substantial risk of recession, there is also a danger that Fed Chairman Ben S. Bernanke will end up being the proverbial “fool in the shower,” who gets scalded after turning the hot water all the way up in a chilly shower. The fiscal equivalent would be opening the monetary spigots wider to pump up the economy, inadvertently creating another asset bubble instead.
“I wouldn’t rule out a half-point cut,” Lyle Gramley, a former Fed governor who’s now a senior economic adviser for Stanford Group Co., told Bloomberg News, “But it’s more likely they’ll compromise on a quarter point [rate cut] and a wide open [policy] statement.”
Jobs Report Opened the Door
The jobs report was key. Let’s go through it:
- Unemployment held steady at 4.7%, which by classic economic standards is essentially full employment.
- Compensation came in at a pretty strong up 0.5%, but can’t be considered inflationary, because we just saw bigger-than-expected gains in productivity, which help offset any wage pressures.
From the standpoint of the FOMC, this report didn’t demonstrate any troubling signs for the economy as a whole. Small businesses – which provide the bulk of U.S. job growth – are generally not experiencing stress from the credit crisis, and U.S. retailers are enjoying a reasonably decent holiday shopping season.
And now that we see employment slowly trending down toward the always-elusive economic “soft landing” – with strong productivity gains and inflation under control – central-bank policymakers will find that they can remain ahead of the curve by reducing the benchmark Federal Funds and Discount rates to keep the credit markets from seizing up. In doing so, the Fed is actually preventing a future far worse than a conventional recession: With its actions, the Fed is actually preventing a deflationary spiral.
Bush Launches Strike Against the Subprime Mortgage Mess
In general, we are strongly opposed to government intervention in the free markets. We’ve all seen how Japan’s reluctance to let free-market forces purge the excesses of its decade-long stock-and-real-estate speculation throughout the 1980s led to the so-called “Lost Decade” of the 1990s. And there’s always the danger that similar results could manifest themselves here by not permitting market forces to purge the excesses of the U.S. housing-and-mortgage markets.
But the Bush Administration subprime-remediation plan – while by no means perfect – in some respects at least represents a strong step forward. The plan will provide a couple of refinancing options to subprime mortgage borrowers, or will freeze their mortgage rates for up to five years.
In effect, what this plan will do is to keep up to 1.2 million foreclosures off the market for as long as five years. If present owners can remain current on their loans for a few years, the housing market might recover enough to allow them to sell and break even, or even notch a slight profit.
Once that happens, those homeowners can move into cheaper digs before the rate freeze expires.
In the near term, this plan keeps us from having still more housing dumped into a market that’s already overstuffed with an inventory of unsold homes, thus keeping housing prices from falling even further. It should also allow the unsold houses already on the market to be absorbed much more quickly than if the glut were permitted to grow even larger.
And it helps that there was broad initial support from the Democrats, since that could speed up the approval process and help ailing homeowners get relief as soon as possible.
Longer-term, by keeping debtors “current” in their loans – and not foreclosing – the Bush plan could also limit the expected magnitude of future problems with both subprime defaults and with the associated negative effects on securitized mortgage packages. That securitized debt is held both by investors and the so-called “structured investment vehicles,” or SIVs, run by banks.
The Bush plan is very good news for the banks, because it stretches the losses institutions would have to take over many years – and very possibly reduces the absolute size of those losses. If it also succeeds in resolving the SIV liquidity problems faster, it will end up being a major step toward resolving the credit crunch.
Downsides to the Plan
The deal’s features aren’t wholly positive, however. The 1.2 million homeowners that won’t now be foreclosed upon next year will “survive” but will also have a five-year clock to watch – a 60-month period during which to either boost their income in order to make their mortgage payments, or to sell out and trade down to much-more affordable housing. Since lots of homeowners will be making these moves at the same time, competition in the market could be quite heated.
Thus, while the program delays these homes from being foreclosed upon and dropping onto the market immediately, it will effectively maintain a sizable percentage of these homes in the sales market for the next five years, albeit in a somewhat-more-orderly fashion.
This should ameliorate the immediate plunge in housing values, but it will keep a lid on any potential price recovery down the road. It should also cap the otherwise onerous losses that financial institutions and investors are taking in the costly foreclosure process in this dead market. This fact alone should make it attractive to banks and investors alike to participate voluntarily in the program: Instead of paying all of these costs that detract strongly from the recovery value of its collateral, a creditor effectively renegotiates with a debtor by giving it this free interest rate swap [from adjustable to fixed for five years] and keeping the loan “current” – with the very real possibility the creditor will actually recover its full value in just a few years.
That actually brings us to a unique interpretation we bring to this. You see, we believe that the voluntary nature of this program effectively makes it a free-market solution. The proposed program will allow the institutions that are saddled with huge exposures to embrace it and work out their problems over longer periods, avoiding the onerous foreclosure process. At the same time, debtors with much-lower exposures will just foreclose and avoid the entire hassle.
The most debatable aspect of the plan is having states issue tax-exempt bonds to aid some refinancings, meaning some costs are passed along to local taxpayers. However, you could also consider that these taxpayers are benefiting themselves, since with a lower foreclosure rate, they will see smaller declines in the value of the homes in their communities.
News and Related Story Links:
- Money Morning News:
Bush Announces Rate Freeze for Subprime Borrowers.
- International Monetary Fund:
Japan’s Lost Decade.
- Minneapolis Fed:
The 1990s in Japan: A Lost Decade.
Structured Investment Vehicle (SIV).
Quarter-point cut, discount rate move seen likely.
Bernanke May Risk `Fool in Shower' Label for Economy.
The Fed's plan B.
- Money Morning:
Housing a “Drag” on the U.S. Economy – and May Spur Another Rate Cut.
- Money Morning:
Consumer Confidence at Lowest Level in Two Years.