Housing and financial markets are in flux. Much "fixing" and reassurances are afoot. The Federal Reserve is promising the moon, banks are suddenly becoming generous with themselves and investors have new faith. The more things change the more they stay the same. The below is an update on financial goings on. The hope is to offer some clarity on seemingly obscure but, important events. Financial market conditions and plans will shape household credit access, credit cost and spending. Why? Because what happens in high finance filters down into the overall economy with greater and greater speed and force. That lesson was made plain when demand for bundled home mortgages hit the wall. As this happened, millions of households lost the ability to refinance and extract cash from their homes. They are now losing their homes, losing their largest store of wealth and facing a credit crunch that will change and restrict their spending. This will shape the economy here and abroad over the next 18 months. We know this because consumer spending is roughly 70% of GDP and US GDP is roughly 20% of world GDP. The financial condition of American consumers exerts influence over approximately 14% of world economic activity. If you stick with me here, it is my hope and intent to demonstrate this to you while explaining what is going on.
The Fed and the Oscar hunt
It is widely believed that studios preen for the Academy in the fall. Hollywood can not hold a candle to the great theatre being put on by banks, the Treasury Department and the Federal Reserve. The three ring show involves a high wire act -- without a net. The sitting members of the Fed continuously reassure us they will be able to fix lingering problems. Former Chairman Greenspan suggests that may not be possible. It is all very dramatic. Echoing -- virtually word for word -- Chairman Bernanke's earlier remarks, Governor Kroszner offers assurance: In the months ahead, the Federal Reserve will continue to monitor developments in the financial markets and act as needed to support the effective functioning of these markets and to foster sustainable economic growth and price stability. October 22, 2007 Fed Governor Randall Kroszner. My paraphrase would be, the Fed will be there to guide market operation and insure the turmoil is contained. I have no doubt that the Fed is staffed with many excellent professionals who are outstanding at what they do. I have no doubt that they are trying to minimize and manage turmoil. The Fed can not guarantee smooth outcomes, stability or containment. They are wise enough to know this. Yet, they regularly say they are doing what they admit they can not do. This is high theatre of the monetary sort. The Federal Reserve's policies target the quantity of credit available and the price of borrowing money, interest rates. Fed fears, hopes, statements and actions are essential shaping forces of debtor and lender reality.
The reality is that the Fed is scared about further turmoil in credit markets. They should be. Financial market professionals, like the Association for Financial Professionals, are increasingly scared and pessimistic. They see credit turmoil lasting and possibly growing worse. The theatre and public confusion arise when opinion leaders downplay risks to avoid disturbing complacent and irrationally optimistic investors. This creates strange Fed commentary: I would suggest that, while we have seen more normal price discovery activity slowly returning to some markets, the recovery may be a relatively gradual process, and these markets may not look the same when they re-emerge. October 22, 2007 Fed Governor Randall Kroszner. My paraphrase would be, markets remain in turmoil and when they emerge, they will look different. These two dramatic statements convey seemingly disjointed assessments of the financial universe. The same man speaking on the same day, has two different takes on market conditions. This is a sign of conflict between the desire to speak in a calming and encouraging way and fears about the speed and direction of change. The Fed and financial community understand that credit is the blood that circulates through the American economic body. Credit brings oxygen, spending power, to the essential organs. Credit cushions the blow as earnings rise and fall. Credit allows people to keep buying. Credit based consumption allows folks to keep working to produce and sell good and services. That is why the Fed is nervous. That is also why it can be confusing to follow the news on this subject. Actions say fear, words sound the all clear.
We are not out of the credit woods. At least Merrill Lynch is still reeling and has been forced to disclose large losses, Third-quarter 2007 results reflect significant net write-downs and losses attributable to Merrill Lynch's Fixed Income, Currencies & Commodities (FICC) business, including write-downs of $7.9 billion across CDOs and U.S. subprime mortgages, which are significantly greater than the incremental $4.5 billion write-down Merrill Lynch disclosed at the time of its earnings pre-release. Losses in structured financial products -- including home mortgages -- continue to emerge and grow alongside continuing deterioration in the housing markets. Merrill is announcing $2.4 billion more in losses than estimated on October 05, 2007. Financial conditions and the fates of millions of highly indebted households are linked. You can not understand either set of issues without the other. This blog is as much a housing story as a financial markets story. It is no accident that the dominant news stories of October 24, 2007 are the losses at Merrill Lynch and record breaking fall in home sales and median home prices reported by the National Association of Realtors. Existing home sales fell 8% from August to September 2007 and 19% between September 2006 and September 2007. Median existing home prices declined greater than 4% in the year between September 2006 and 2007. The NAR Chief Economist's explanation was turmoil in the mortgage market. Mortgage problems were peaking back in August when many of the September closings were being negotiated, and that slowed sales notably in higher priced areas that rely more on jumbo loans. The financial story and the housing story are actually one story. The housing story and consumer spending are intertwined. Consumer spending drives the US economy and has a huge global impact.
Banks see this reality and are generously setting up a bail-out fund -- for themselves. It is their hope and wish that Christmas will come early to distressed off-balance sheet "assets." Don't let the names and terms confuse you. The idea is for banks to set up a fund to buy or loan to investment vehicles they established. Why the need for this concerted action? Funny you should ask. Remember that credit crunch, it is not over and the banks don't see it ending soon enough for their tastes/needs. CitiGroup and the Treasury Department have convened meetings to work toward an industry led solution. They sure are not going to get caught waiting and losing money while hoping the credit crunch is over.
M-LEC the Beneficent
The Master Liquidity Enhancement Conduit (MLEC) is the brainchild of the US Treasury's Hank Paulson, CitiGroup, JPMorgan and Bank of America. Their plan is to attract commitments of assistance and contributions from leading financial institutions to a buy-out fund. Contributors would receive fees and help support the value of their similar assets. Contributing institutions would be helping to restart a still disabled and important source of funds, the commercial paper market. They would be acting to restore function and confidence in financial markets. Commercial paper and other short term lending markets are vital source of credit (less than 270 day loans). The commercial paper market has declined by 25% since turmoil struck in late July. The MLEC fund would buy assets others are having trouble selling or borrowing against. The fund would bring the assurance and deep pockets of leading institutions. Banks, particularly CitiGroup, have been disadvantaged by an inability to borrow against asset backed securities. They are anxious to sell these securities but, there are few buyers and prices would have to be slashed. The results reported by Merrill Lynch should stand as a warning about how large the losses could be from revaluing structured financial products, including mortgages. Restoring faith in markets and creating demand for their products could be a profit life saver.
New regulations, like FASB Reg. 157, will make it harder to avoid including and reporting losses. Loans were made to companies, homebuyers, credit card holders, university students and corporations. The promises to repay and collateral pledged were bundled into securities and sold. Once sold, these assets backed borrowing in the commercial paper market. As faith in repayment fell, fewer and fewer institutions wanted to lend against or buy structured financial products. Discounts -- in some cases very large discounts -- are demanded. A solution could be provided by buying out some of the assets and restarting lending. Investors and banks were lulled into a dangerous practice during the good old days -- just like homeowners. They borrowed short term money and assumed that cheap and fast option would always be there. The decline of the market was large and rapid. It has come back only very slowly and partially. MLEC seeks to use coordinated bank buying, approved by the Federal Reserve and Treasury, to re-open access to borrowing and prevent losses.
Banks are debating how generous to be with each other. Regulators are acting like they fear the future and assuring us we should not. Housing markets and consumers are losing steam, fast. There are no free lunches in this world and nothing will be done simply to help others. Firms in stronger positions will extract revenues and concessions from those in need. Distressed homeowners and debtors will see their fortunes float with credit market conditions and the overall economy. General improvement would require easing the credit crunch and more. Real stability and health going forward requires less reliance on debt and less financial fragility in American households. The MLEC represents an attempt by leading banks and government regulatory agencies to prevent further trouble from ongoing financial turmoil. It remains to see if this plan will fly. Even if it is attempted that is no guarantee of success. As turmoil continues, housing and general economic weakness are very, very likely.
If you stuck with me across this romp, you now understand that what this means. We have significant ongoing financial turmoil. There has been some improvement. There is plenty further to go and it remains unclear if things will get worse before they get better. Leading regulatory agencies are full of reassuring words but their actions suggest fear. The financial markets and institutions that supply the credit life's blood of the US economy are looking for government assistance and help from one another. Housing is and will remain under pressure. This is all one story. Right now it is the story of American households, banks and financial markets. Given the size and importance of American households, banks and financial markets, this is a central drama in the global economy.