Market Update 1 26 10...I can get you negative yields on short Treasuries if you're interested

Today is Fed day.  That sentence means less now than at any point in time than I can remember.  The Fed is on hold and they’ve taken every opportunity to tell us they will continue to be on hold for “an extended period of time”.  There is no inflation showing up in the economic data, the housing market stinks, unemployment is at 10%, and everyone in the free world is looking over their shoulder for signs of the commercial real estate crisis to emerge.

 

For the first time in almost a year we have the one-month T Bill trading at a negative yield.  As many times as that has happened in the last two years I’ll never get used to seeing it.  It’s a bit like an old lady in a hybrid car beating you off the line at the stop light…theoretically you know that it’s possible but you never fathom you’d actually see it (don’t ask me how I know this). 

 

Perhaps the biggest question in the market currently is “what will happen when the Fed exits their MBS purchase program?”  That program is scheduled to end in March.  A quick bit of history is in order at this point.  This MBS purchase program was started as a method of maintaining a very liquid mortgage market in the face of a global liquidity crisis.  The large Wall Street firms that normally provided this function were getting hammered with capital write-downs and several large firms went bankrupt.  Normally those firms maintained large inventories and had very active trading desks and they served as very efficient market participants that provided deep and liquid pools of capital for the US mortgage market.

 

As that pool of liquidity began to evaporate, the Fed stepped in to insure that the US mortgage market could operate effectively.  A secondary goal of the program was to keep MBS spreads low so that more people could refinance their mortgages.  If good borrowers could refi their mortgages then they’d have more spending money in their pocket each month; this in turn would boost consumer spending and help speed the economic recovery.  Another goal was to help borrowers in exotic and unaffordable mortgages transition into traditional and more affordable fixed rate mortgages at low rates.  If more of these borrowers could get traditional mortgages it would in theory stem the tide of foreclosures, and therefore limit further home price depreciation.

 

Sounds easy doesn’t it?

 

Well it’s not easy…and nobody in the real world thought it would work the way the Fed pitched it.  It was a bit of a Hail Mary pass.  Go big and hope it works.  The way the Fed envisioned it is that by the 3^rd quarter of 2009 the markets would be back to their normally efficient state and that they could just hand the baton back to the market and let it do its thing.  Over time they would gradually liquidate their positions in an orderly fashion and they’d all look brilliant for averting a housing crisis, helping borrowers, and returning the economy to a path of prosperity.

 

The 3^rd Quarter 2009 deadline has long since passed, the Fed owns roughly 34% of the entire MBS pass through market, the next deadline is approaching and they openly question whether they may need to own even more of the market.

 

The first time home buyers program is due to end on 30 April 2010.  It is difficult to see the Fed doing anything that will cause mortgage rates to rise while the administration still has a program under way to help boost home sales.  In fact it’s difficult to see them ending this program at all while the housing market is still in shambles.  I’m not saying it’s a good program…I’m just saying that I don’t see them giving up and walking away from it.  The Fed needs mortgage rates to remain low…and until there is another entity in the market that can take their place it appears that they are stuck between a rock and a hard place.  This program appears destined to be remembered as a very expensive program with very limited results.  The real pain of the program has yet to be felt as the Fed hasn’t had to deal with owning $800 billion of long mortgages while rates are rising.  I’d love to be a fly on the wall when they look at their up 300 rate shock.

 

Who will take their place?

 

It’s very interesting to me that they Fed wants to get out of this position as the largest participant in the MBS market, but at the same time the administration is beginning to wage a war on the very institutions that the Fed needs to take their place.  The more restrictions the government places on the banks the less able and/or willing they will be to step in to take the place of the Fed in the MBS market. 

 

As a wild card scenario, it could evolve that the Fed ends their MBS purchase program to test the waters, only to have Fannie or Freddie pick up where they left off if mortgage rates rise too much.  Fannie and Freddie now have unlimited capital lines from the US Government.  The end result would be no different…it would just be a different government entity manipulating the market.

 

It’s very difficult to see an exit point for government involvement in the mortgage market any time in the near future.  I still see rhetoric about helping borrowers in unaffordable mortgages, modifying mortgages, reducing payments and principal balances, etc.  I’m not hearing anything in the news that leads me to believe that the government thinks that LESS involvement is the best course of action.  NOBODY even mentions “equilibrium levels”  or “supply and demand” when they discuss the housing market. 

 

I think it would be very refreshing to see someone go “off script” at a news conference and say something along the lines of “The housing market will continue to be a complicated mess until we get out of its way and allow prices to reach a level where buyers are interested.  An unfortunate and painful fact in this process is that some people will lose their status as homeowners, but it’s not fair to raise taxes on those that CAN afford their home so that we can keep the dream alive for those that can’t.”  I know…I’m dreaming.  Instead we’ll continue to get programs that ask the taxpayer and the lender to eat the loss.

 

Stimulus Bill update

 

We have a mall attached to our office, the mall has a food court, we sometimes get lunch there.  In the food court there was a Steak Escape restaurant.  Through the magic of the $787 billion stimulus bill the owners of the Steak Escape were able to close the franchise and re-open under a new name.  They weren’t going out of business…they just changed the name.   These jobs get counted as “saved or created” at an average cost of $1.2 million per job.

 

So the government spent $787 billion to insure that I was able to get a sandwich yesterday from the same people, in the same location, serving the same food as I was able to get a month ago.  I thought the sandwich was expensive at $7.49 for the combo meal…but considering that they had about $10 million worth of stimulus bill employees serving lunch I really feel like I got a deal. 

 

I don’t even want to think about how many steak sandwiches they have to serve before the government breaks even on the investment.  Who knows…maybe they’ll give a free sandwich to all taxpayers on April 15^th.

 

If you have any questions or if there is anything I can be doing for you just let me know.

 

Steve Scaramastro, SVP

800-311-0707

 

Interpolated Yield curve

Each month Bloomberg surveys 60 to 70 economists to get their estimates of where Fed Funds, the 2-year Treasury, and the 10-year Treasury will be over the next several quarters.  I take this data and interpolate for the points in between the survey data to create the attached report.  This allows us to get a broad view of where various economists see interest rates going over the coming quarters.

 

This study uses the average of all responses in the Survey.  Using the Median response shows that the group expects no change in the overnight rate until at least the 4^th quarter of 2010.  We still have a lot of economic data pointing to a very sluggish recovery so I wouldn’t be surprised to see that forecast for higher rates getting kicked down the road in next month’s survey.

 

If you have any questions or if there is anything I can be doing for you just let me know.

 

Steve Scaramastro, SVP

800-311-0707

 

 

 

 

 

 

 

2009 Year in Review

 

A new year is upon us

 

The year 2010 in China is the year of the Tiger (pretty ironic if you’re a golf fan ‘cause it won’t be the year of the Tiger on the PGA tour), but in the USA it looks like it will be the Year of the Bair…Sheila Bair that is.  As we begin the “Year of the Bair” I thought it would be helpful to do a quick review of 2009.  Before we begin, I’d like you to take a moment and think of how you would sum up 2009 in one or two words.

 

The Google method

 

If you had to give one or two words to a person researching the 2009 economy using a Google search, what would you tell them to type in?

 

I leaned back in my chair this morning with a cup of coffee and reflected upon the year we just witnessed, and the first description to pop into my head was “government intervention”.   That’s how I’d have to sum up the year.  If the government COULD get involved with it, then they DID get involved with it...whether they needed to or not. 

 

If I Google “Government Intervention” I get 11 results on the first page.  10 of those results deal with the economy…and none of them are links to government agencies.  So I get a lot of information from independent sources that are all very interested in the topic of government intervention as it pertains to the economy.  Clearly it’s a hot topic.

 

If I Google “Recovery” I get 10 results on the first page.  The first hit on the page is to a government run website that proclaims that 640,000 jobs have been “saved or created” by the stimulus program.  That’s clearly not an independent source of info so I’ll ignore it.  Two others are links from groups that benefit from government spending so I’ll discount those too.  The rest of the hits on the page are for alcohol and drug abuse recovery…ironic since many are probably in this condition due to stress over the economy.  I get zero hits from an independent source anywhere in the world talking about a current or impending economic recovery.  It appears that nobody outside of those that stand to get re-elected or those that stand to benefit from stimulus spending are writing about economic recovery at this point.

 

We might have a new data series in the making here.  It would seem to me that if we were having a recovery that we might see fewer Google search results for help with alcohol and drug problems...the fewer substance abuse hits you get on a Google search for “recovery” the stronger the economic activity.

 

I haven’t patented this methodology yet so feel free to run with it.

 

The 2009 short story

 

As always I try to sum up the Year in Review for those that don’t have the time or the inclination to read the whole thing.  For you I provide the following summation:

 

·         Economy avoids depression, lands in a bad recession

·         Tax evader appointed to run Treasury Department

·         Government passes $787 billion stimulus bill

·         Unemployment rises from 7.6%to 10.2%

·         Government tries to fix the problems of too much consumer borrowing and loans to poor credits by borrowing as much money as they can from the rest of the world and pressuring banks to lend money to the same deadbeats that won’t pay them back now (it seems counter-intuitive but trust them…they must know what they’re doing). 

·         Fed drives MBS spreads lower by buying 35% of the market

·         Fed gets into program to buy MBS and can’t get out, deadline pushed back

·         Fed funds started and ended the year at zero percent

 

In the beginning

 

At the start of 2009 we were still operating in the shadow of Paulson.  We started the year with the TARP hearings on CSPAN which turned out to be a wonderful opportunity for America to get an idea of just how little their elected representatives knew about the current economic problems.  We then moved on to the stimulus bill which was a wonderful opportunity for our elected representatives to prove us right in our assessment of how little they knew about the current economic problems. 

 

The Fed and Treasury were scrambling to keep the economy out of a depression and the politicians were scrambling for an opportunity to look good and to get their hands on some money.  The fear of the next Great Depression eventually eased but we were left looking at a landscape of increasing unemployment, massive political intervention in the markets, and a prolonged recession.  It’s a bit like swerving to miss a deer and hitting a light pole instead.

 

2009 started out with a battered and highly leveraged American consumer being forced to come to terms with reality.  All of the tools that the consumer used to fuel his consumption binge were going away.  Credit card companies were cutting limits and raising rates, banks were cutting off home equity lines, stocks were in the gutter, and home prices were dropping from coast to coast.  The consumer was at the station and he had to watch the last train to Consumptionville leave without him. 

 

The consumer had been under fire for months by the time December 31^st 2008 rolled around and by the start of 2009 he had boosted his personal savings rate from the 2008 low of 0.4% of disposable income to 4.7%.  This is still below the long term average for the country but it represented a substantial shift in sentiment.  The consumer was scared…and rightfully so as he was entering the year of job destruction and he’d need all the cash he could get his hands on to survive.  This was perhaps the first time that people stopped counting “available credit” on their credit card as a component of their personal liquidity figures.

 

The year of job destruction

 

No comprehensive discussion of 2009 will ever be complete without mention of unemployment.  History will record that the high water mark for Initial Jobless claims was 3/27/09 when the report for that WEEK showed that 674,000 Americans filed for first time benefits. 

 

The record will also show that 6/26/09 was the high point for workers on the Continuing Claims list…6.9 million people were on the rolls that week. 

 

One shortcoming of these numbers though is that they are static…they are just snapshots of a moving machine.  They don’t show that as the year rolled-on roughly 18 million Americans received an unemployment check at some point during the year.  They don’t show that roughly 23 million Americans are “underemployed” as defined by being either completely out of work, or forced to work fewer hours than normal, or have to work at reduced wages.  These factors all have a significant negative influence on future growth prospects for our economy.

 

It’s great to see the trend in the jobless numbers slowly coming down.  I’m all for seeing 440,000 people file for initial claims in a week vs. 674,000…but neither number is great.  The definition of economic growth isn’t that we “fire fewer people”.  We need to get a tremendous number of people back to work before we return to a “normal” level of economic growth.  The current Unemployment Rate is 10%.  The long term average unemployment rate in our economy is roughly 6%.  The work force in the US is roughly 154 million people.  This means that to get back to a “normal” unemployment rate we need to put over 6 million people back to work. 

 

One big concern is that when the dust settles on job losses that we’ll have a large number of unemployed persons that stay that way.  That situation would act like an anchor on the economy that keeps us mired in low economic growth or perhaps bouncing in and out of recession over a period of years. 

 

The long term average level of GDP in the US is right around 3.00%.  The concern is that the combined effects of this recession and the “fixes” that the government has applied will combine to generate a “new normal” somewhere in the 1.00% to 2.00% range for GDP…an unattractive scenario by any measure.

 

Intervention

 

I won’t be able to comment on ALL of the intervention that took place last year but I can comment on activity in the places that affected banks and their investment portfolios the most. 

 

In 2009 the Fed embarked on an ambitious program to make mortgages more affordable by purchasing $1.25 Trillion worth of MBS and Agency securities and an additional $300 Billion worth of US Treasuries. 

 

The idea was that you drive down Treasury rates AND MBS spreads which make mortgages more affordable, people can refi, they have more money in their pockets, they spend that money, and the economy recovers.  Another goal was to keep rates on non-Agency ARM structures from rising any further and giving those borrowers a chance to get into a low rate traditional mortgage.  This would help avoid a massive wave of foreclosures, thus avoiding additional over-supply/price depreciation in the residential real estate market. 

 

So the plan was that they’d do all of this to keep the markets efficient and functioning, and then before the end of 2009 they would just step out of the middle and hand the baton back to the now efficient market and things would all go very smoothly going forward.  Fat-chance.

 

I don’t personally know anybody that thought this would go off without a hitch.  Over the past year we’ve called it a quagmire, we’ve said that the Fed has gotten mud-sucked, that they will have to extend the programs.  The Fed did indeed have to extend the end-date on their MBS program.  It was supposed to end the 3^rd quarter of 2009 but they had to push the date out to 1Q 2010.  To date they’ve purchased roughly 35% of the entire MBS pass through market…and the notes from the FOMC meetings have indicated that some members believe they should be prepared to own an even greater percentage. 

 

Intervention and community bank portfolios

 

This program has been both good news and bad news to community banks at the same time.  On the one hand it’s good news for us because we were able to buy MBS at spreads anywhere from 150 to 300 bps over Treasuries in 2008 and into 2009.  We were telling everyone that would pick up a phone to buy MBS over that time period.  Most buyers did buy them and they have been well rewarded as the Fed purchases achieved at least one of their goals…pushing spreads lower…in the process prices rose.  Those buyers have great yields and big gains on those bonds.  Those that have loan demand are now able to take large gains on sale AND roll the proceeds into even higher yielding loans.  What’s not to love about that? 

 

The bad news is also that the Fed managed to push spreads lower.  Big premiums are now the norm in MBS.  These premiums bring with them their own set of risks.  Lower yields and more prepay risk confront new money entering this sector.  There are still plenty of attractive opportunities here…there just aren’t as many slam dunks as were available in early 2009.

 

Going forward we need to watch this program.  When will the program end?   How much of the MBS market will they ultimately own?  If they are able to exit this role as the largest buyer of MBS, how will the market react?

 

A poor man never gave anyone a job

 

A tremendous amount of Treasury debt was issued in 2009.  An unfortunate fact associated with this debt is that we’ll eventually have to pay the money back.  The concern is that this will require higher taxes in the future that will serve as a drag on economic growth. 

 

This weekend I was reminded of the old phrase that “a poor man never gave anyone a job”.  Taxing the engines of job creation will certainly retard growth in the future.  Every dollar taken by the government in the form of taxes is a dollar that can’t be saved or spent on infrastructure development, employment, or consumption.  The thought that the government is a better steward of that dollar than the man who earned it doesn’t sit well with me.

 

I was reminded of this last weekend while I was attending a few games at the new Dallas Cowboys stadium.  The stadium cost $1.3 billion to build and it employs 4,000 people in long term jobs.

 

The stadium is wonderful.  It is run very efficiently, the employees take great care of your every need while you are there, it is laid out well for entry and exit, 3,000 flat screen TV’s are distributed throughout the stadium to insure that you don’t miss a minute of the action no matter where you are, and they have the largest high-definition TV in the world (the TV over 11 thousand square feet of extravagance).  Jerry Jones spared no expense when building this thing.  It employs 4,000 people and provides no telling how much in the way of business to local merchants and sales tax revenue to Dallas County.  The Cotton Bowl had a crowd of 77,000 people and the Dallas/Eagles game had just over 100,000.  Serious revenue flowed through the place.

 

I thought I’d use the new Dallas Cowboys Stadium as a comparison to government spending efficiency.  The stimulus bill was a $787 billion endeavor.  The government released a figure that with that money they had “saved or created” 640,329 jobs.  Simple math tells me that it took them $1,229,055 to create each job.  I’m giving the government a huge amount of leeway here because their jobs “save or created” number has been widely criticized as fraudulent.  For the sake of the argument I’ll give them full credit.

 

By comparison Jerry Jones created 4,000 jobs, built a modern marvel of infrastructure that is the talk of the country, and that will provide tax revenue for Dallas County Texas for many decades to come.

 

Using the governments dollars-per-job figure it should have cost Jerry Jones $4.9 Billion to pull this off.  In reality he got it all done for $1.3 Billion. 

 

One American entrepreneur with a limited budget (albeit a large one) created thousands of long term jobs in a far more efficient manner than could hundreds of bureaucrats who had virtually no spending cap.  This is but one example of how private sector spending is much more efficient than government spending.  As a closing thought, I’ll leave you with this question:  How many successful business owners have you spoken with that say “man my business sure was a mess until the government stepped in and got me straightened out.”?

 

Here’s to the American entrepreneur…and here is to less government intervention in 2010.

 

Bank closings

 

As of November there were 552 institutions on the FDIC’s Troubled Bank list.  As recently as 2007 bank closings were rare enough that I’d actually work up a spreadsheet on historical performance for each institution that the FDIC closed.  The pace of closings has increased to a point where we really don’t even keep track anymore.  Banks are dropping like flies and there is no time to stop and dig into the details.  They close them on Friday and they are open under a new name on Monday. 

 

2010 is widely expected to be a year that sees a tremendous number of bank closings.  To date the pace of closings has been constrained only by personnel and capital.  The FDIC has been hiring with a purpose and they are getting fresh capital soon so look for a spring offensive. 

 

The End

 

So that was 2009.  Some big questions to ponder as we enter 2010 include:

 

Will job creation take root?

Will the Fed raise rates?

Will the Fed be able to exit their MBS purchase program?

If they can exit, then how will the market react?

Can the Fed sop up the excess liquidity in the market if they need to?

Will foreign central banks continue to fund our deficits and help us keep rates low by purchasing Treasuries?

How steep will the yield curve get if foreign banks tire of buying Treasuries?

How will that steepening affect me?

Stagflation?

Inflation?

Double dip recession?

Will the Commercial Real Estate problems destroy prospects for a good 2010?

Will persistently high unemployment cause another round of foreclosures and credit losses?

Will Tiger Woods ever golf again?

Why can’t a Cadillac Escalade take more front end damage at 5 MPH?

 

All kidding aside there are a lot of big questions to wrestle with as we begin the year and plot our course.  If you have any questions on this material or if there is anything I can be doing for you just let me know.

 

Happy New Year,

 

Steve Scaramastro, SVP

800-311-0707