Should We Blame the Fed for Sub-Prime’s Woes?

I just heard an argument about this and I think it’s extremely unfair to blame the Fed for the current crisis in the sub-prime mortgage industry. The rationale for doing so postulates that without record low interest rates for so long, the housing market would not have overheated. As a result, many lenders would not have made loans to customers who wanted to buy a house so badly that they might not disclose, or even lie, about their financial condition.

I have a problem with this logic. The sub-prime meltdown was not caused by low interest rates. Instead, it was caused by loose lending standards. The lenders gave loans to people who couldn’t afford them. If you don’t require prospective home buyers to verify their annual incomes or net worth, and you give them mortgages without a down payment and low teaser rates, you need to be responsible for the consequences of such actions.

The sub-prime lenders that are in trouble are the ones who gave loans to people who couldn’t afford to pay them back, either right from the start, or when their ARM’s adjusted upward a few years later. You have to blame the business people who made the loans, not the people themselves. If you blame the Fed, then you are saying that high demand for mortgages was the problem. However, the problem seems to be that the bankers actually matched the high demand with a huge supply of loans.

Corporations are not required to accept every customer that comes knocking on their door. Rather, they have a duty to shareholders to do business that is profitable and in the best interests of the owners of the business. If they fail at managing their company adequately, which has been the case for most sub-prime lenders, the only people they (or anyone else) should blame are themselves.

Has the Housing Bubble Burst?

All I’ve heard recently in the financial media is that the housing bubble has finally burst. It’s really quite comical. First of all, there was never a housing bubble. Everyone just threw around the bubble term because we had experienced one in Internet stocks a few years back and it was easy to categorize a very strong housing market as a bubble.

It’s true that the housing market of the last five or six years was one of the strongest we have had in this country. The same can be said of the broad stock market from 1982 to 2000. We had the biggest equity bull market ever. However, it was not a bubble for all stocks, only one sector of the economy. Technology and telecom names fell by 90, 95, even 100 percent.

Outside of tech though, there was no bubble in stocks. The S&P 500 fell 50% when the “bubble burst” but the Nasdaq fell 80% and tech made up 30% of the index. As a result, half the S&P 500 loss was from tech stocks. Without the bubble, the market would have been down 25%. That classifies as a bear market, not a bubble.

Markets don’t experience bubbles every five or ten years. It’s a much rarer phenomenon than that. People are also calling the bull market in commodities as a bubble. It’s not. It’s a bull market. Markets are cyclical and when they rise they do so very quickly, but bull markets and bubbles are not synonymous terms.

So, yes, the housing market is very weak, but let’s stop saying how the bubble is bursting. The mean home price in the U.S. remaining flat or only rising 1 or 2 percent does not classify as a bubble bursting. Not even a 20% drop in housing prices on the coasts qualifies. That’s just a bear market, which is what typically follows a bull market. When housing prices in certain markets fall by 90% or more, then we can start calling it a bubble. Not going to happen.


Despite Housing Weakness, Cashouts to Jump in 2006

Given that we know the housing martket is slowing dramatically and interest rates have been on the rise for a while now, it may be surprising to many that Americans are expected to draw $257 billion out of their homes in 2006, up $13 billion versus 2005 levels, according to Freddie Mac. This likely helps to partly explain why the consumer has yet to fall of a cliff despite housing market woes.

The bearish argument for consumers has been the fact that billions in adjustible rate mortgages are set to begin resetting this year, which will shock the monthly budgets of many people who could only move into the house they wanted with very low teaser mortgage rates. However, it appears that refinance activity is picking up as ARMs are about to readjust. With 30-year fixed rates around 6.5%, hardly an unaffordable rate for most, refinancing adjustible rate mortgages into fixed mortgages are helping to cushion the blow.

Now it’s certainly true that even a move from 3% to 6% might prove too much of an increase for some lower end home buyers and speculators, but it is hardly something that seems likely to send the U.S. economy into recession all by itself. I do expect housing to remain weak for a while, given that inventories are hitting multi-year highs. However, unless mortgage rates take a dramatic turn upwards, say to 8 or 9 percent, consumers might be able to hold up a little better than some expect.

Fed Meeting Preview

As we head into the FOMC meeting today, I wish I was a bit more optimistic. The market has priced in a pause in rate increases and a definitively more “dovish” policy statement. The last time I saw the Fed Futures it was around 18% for a rate hike today at 2:15 ET.

Even if we get what the market expects, will the market make a nice run to the upside? I doubt it. We could get an immediate pop, but I don’t think it would hold up. There will be plenty of sellers looking to slim down positions if we get something like +100 on the Dow this afternoon.

The other alternatives suggest we might see reasonable selling pressure. I’ve said here lately that I think we could very well get a 25 basis point hike today. I think the 18% chance that the futures markets have priced in is too optimistic. That said, the hike itself isn’t catastrophic, so long as the Fed makes it clear in their statement that it is the last one for a while.

This is where the problem comes in. I don’t think the Fed will want to say anything that makes them look “dovish” on inflation. Their policy statement, whether they raise rates today or not, might very well talk tough on inflation and indicate that while they are pausing for now, if they continue to see inflation pressures they won’t hesitate to raise rates later in the year.

Such a development would likely cause a market sell-off, making today’s highly anticipated Fed meeting fairly disappointing for those of us who own stocks. I sure hope I’m wrong and we see stock price advances from here over the near term. But if that happens, I would be tempted to take some money off the table. If others feel the same way, any rally will likely be short-lived.

Full Disclosure: With the Dow +43 this morning, I have initiated a short trading position in the Spiders (SPY) for my personal account in anticipation of the gains fading after the Fed decision is released.


Will Bernanke Throw Investors a Bone?

We know that interest rates hikes work with a lag, so it takes 6-12 months for the effects to ripple through the economy. We know that we’ve had 16 straight rate hikes that has taken the Fed Funds rate from 1% to 5%. Shouldn’t Chairman Bernanke and the FOMC take a break, and see how the two-year long rate-raising campaign affects everything?

That’s the case for the Fed to quit. I’m in that camp, personally. It’s not like the Fed can’t raise rates whenever they want to anyway. If they pause for a month or two and regret it, you can always go back and raise some more. Would such a plan have any drastic repercussions? I doubt it. And let’s not forget, even though the market gets on a regular timeline with the FOMC meetings, Bernanke and Co. can move between meetings if they need to.

The way I see it, the stock market has stabilized after getting down to S&P 1,225, 8% below the highs. It has a little room to rebound, given the chance. If we get more of the same later this week from the Fed, and by that I mean a 25 bp hike and a similar statement to recent ones, equities will have a tough time to hold current levels. Uncertainty is always bad for stocks. If we get a signal that this hike is the last one for a while, I think can get a brief rally that might get us to back close to 1,300 on the S&P 500. At that point, I’d probably do some selling.

Another less likely option, but a good one nonetheless, would be to move 50 bp this week and signal a pause. This would satisfy both those looking for a hawkish stance on inflation, as well as a pause to observe the ultimate effects of all of these hikes. I think the market would rise in this scenario as well. I hope Bernanke decides to take a wait and see approach, but we’ll just have to, well, wait and see.

Bernanke Era Begins

Just how different will today’s Fed meeting be compared with those of former FOMC Chairman Alan Greenspan? Will the Fed’s all important statement be a lot more clear and straightforward, or will it be only slightly tweaked from those used over the course of the last several years? These are the questions investors and economists are eagerly anticipating getting answers to as we await the outcome of Ben Bernanke’s first meeting as head of the FOMC.

I think the wording might be slightly different under Bernanke, but those looking for bold shifts in policy wordings might be disappointed. We will get a 25 bp hike today, but where do we go after that? Will 4.75% be the end, or are we going to 5.00% or 5.25%? I think the case can be made that 4.75% is enough. Surely anything above 5%, given the current economic climate, will spook many investors.

Most importantly, what does this mean for the stock market? The market has been acting very well lately, and in my mind that signals we are pricing in the end of the rate hike cycle. If that’s the case, those expecting a huge rally when the Fed does get around to stopping will likely be met with sellers looking to book the gains earned in recent months.

Housing Inventories Hit Record High

“The backlog of unsold new homes reached a record level last month, as sales slipped despite the warmest January in more than 100 years. The Commerce Department reported Monday that sales of new single-family homes dropped by 5 percent to a seasonally adjusted annual rate of 1.233 million units last month. That was the slowest pace since January 2005 and left the number of unsold homes at a record high of 528,000.”

The housing boom is over folks. Inventory data is crucial for real estate. There is no magic formula for calculating fair value of residential housing. You can’t run a discounted cash flow model, or dividend discount model. Housing prices are simply based on supply and demand. And supply is at an all-time high.

Even here in St. Louis, hardly a booming market, I am seeing more and more houses going up for sale, even though others have been on the market for months. Mortgage rates are up and millions of ARM loans readjust this year. Home equity loan rates are also on the rise. Fed Funds will hit 5% this year, which puts the prime rate at 8% and most home equity loan rates at 9%.

It’s not a complex scenario. Supply is high as the inventory numbers show. Interest rates, the cost of money, are going up and will adversely affect demand. Not a good combination. Housing stocks may look attractive with low P/E ratios, but don’t forget why housing stocks always have low multiples; because the cycle always ends.

Bernanke Reign Begins

The markets really aren’t reacting much, if at all, after newly appointed FOMC Chairman Ben Bernake answered questions on Capitol Hill today. Aside from Bernanke’s preference to avoid partisanship, his answers and views on the economy were very similar to Greenspan’s. As far as interest rates go, I continue to think we’ll see 5% Fed Funds this year.

Implications for the stock market aren’t very bullish in such a scenario. Stocks tend to be flat to slightly down after the last hike of a rate tightening cycle, and any move above 5% Fed Funds would indicate inflation is fierce enough to further crimp corporate profit growth. All in all, there are many excellent investment opportunities out there, but index funds won’t fall into that category in the short-to-intermediate term, in my view.

Despite Real Estate Boom, Stocks Still King

Here’s a pop quiz:

By how much has the domestic residential real estate market outperformed the S&P 500 index over the past three years?

The U. S. real estate market has seen its biggest boom in history in recent years. Investors who have moved away from the stock market and shifted their assets into housing are probably very happy they made such a move. But should they be? It depends, but the numbers themselves tell an interesting story.

Since 2003, residential housing prices in the U.S. have risen by 10 percent per year. In fact, the annual returns have been accelerating, 7% in 2003, 11% in 2004, and 12% in 2005. Despite such a strong market, investors in the stock market have actually done even better, as the S&P 500 has advanced 13% per year during the same period.

If a huge housing boom can’t even match the stock market’s performance, it serves as yet another quantitative example of why equities have outperformed real estate by a factor of three throughout history.

Bernanke Is A Solid Pick

Fortunately, President Bush decided not to throw us a curve ball today with his appointment of Ben Bernanke as the next Fed Chair. Recent history clearly had the market a bit spooked with Greenspan’s successor yet to be named, but a relief rally on Wall Street is underway. Bernanke really has only been in the spotlight in recent months, as potential replacements were discussed. Nonetheless, his credentials are strong and I think the market was hoping he’d be Bush’s top choice.

I still believe Greenspan wants to “finish what he started” and will likely bring Fed Funds up to 4.5% before he moves on in late January. If this view proves true, and Bernanke doesn’t continue boosting short-term rates, we could see a nice market rally back to the upper end of the trading range between now and sometime in the first quarter, as the rate hike barrage would be over. That would certainly be welcomed by investors, myself included.