Market Update 2 24 10 _ Bernanke Testifies

Testimony

A growing chorus of Fed officials have spoken in the last week and stated that the overnight rate ain’t going up any time soon.  It’s getting loud enough that it is difficult to ignore.  In the last week we’ve heard this sentiment from the following Fed officials:

-          St. Louis Fed President James Bullard

-          San Francisco Fed President Janet Yellen

-          New York Fed President William Dudley

-          FOMC Chairman Ben Bernanke

This morning Bernanke testified before the House Financial Services Committee that low levels of resource utilization and stable inflation expectations are combining to create a need for exceptionally low Fed Funds levels for an extended period of time. 

Additional factors cited were:

-          Weak job market

-          Unemployment rate near 10%

-          40% of unemployed have been without a job for 6 months or more

-          Job openings are scarce

Jobs

As he has done in his prior writings, Bernanke is stressing that job creation involves the extension of credit to small businesses.  He is going to work with banks to ensure that they are giving small businesses a “second look” when it comes to lending. 

More than one question in this morning’s testimony was directed toward bank lending and job creation.  At every opportunity Bernanke stressed that the Fed is working with the banks that they supervise to insure that small businesses can get access to credit.

The peanut gallery

The entertainment value of watching these sessions is priceless.  If the testimony were turned into a movie I wouldn’t know if I would place it in the “Comedy” genre or the “Horror film” genre.  It’s kind of a hybrid.

For instance, when it was Ron Paul’s turn to ask a question of Bernanke he went on a long and rambling diatribe where he accused the Fed of a wide range of activities; from funding the 1972 Watergate break in to perhaps propping up the country of Greece.  When he was finished the camera flashed to Bernanke for his response.  The Chairman looked off into the distance for a moment, mouth slightly agape, as if searching for just the right words.  When he spoke he said “Congressman, the specific allegations that you’ve made are absolutely bizarre” and “I have no knowledge of anything remotely like what you’ve just described.”

It reminded us of the scene from Adam Sandler’s movie “Billy Madison” where the following exchange takes place following Sandler’s answer to a debate question:

Principal: Mr. Madison, what you've just said is one of the most insanely idiotic things I have ever heard. At no point in your rambling, incoherent response were you even close to anything that could be considered a rational thought. Everyone in this room is now dumber for having listened to it. I award you no points, and may God have mercy on your soul.

Billy Madison: Okay, a simple "wrong" would've done just fine.

 

From the scary movie aisle comes Maxine Waters’ turn at the microphone.  This might win the train wreck of the day award.  Congressman Waters statement began well enough…we all thought for a moment that she was going to stumble into a good question…and then right when we thought she was gonna lay it down…it all came off the tracks. 

It became frighteningly obvious that Senator Waters not only doesn’t understand the difference between the Discount Rate and the Fed Funds rate…but she is incapable of understanding it even when the Fed Chairman himself is explaining it to her.

She was adamant in her belief that raising the discount rate would cause an immediate upward shift in ARM rates.  Even after Bernanke explained to her that there is no linkage between the Discount Rate and ARM rates she didn’t give up.  She pressed him for a guarantee that it wouldn’t happen.  It’s a bit like a depositor thinking you’re going to move the location of the drive-through window if they get a new car.   

She simply could not get past the fact that there was no logical basis for her question.  Despite Bernanke’s best efforts to straighten it out and get her an answer to a question that actually made sense, she clung to her initial inquiry as if she could turn it into a “gotcha” type moment.  It is both funny and sad to me that the Fed Chairman has to testify to a room partially filled with people that have no hope of even understanding the problems we face…much less be able to provide answers to them.

There are some good questions, but just when you feel like there is some hope and that the conversation is moving in the right direction, another doozey comes out. 

I’m frequently surprised by how far my little Market Update gets distributed.  I know that a few people on the list are only one “forward” away from the Chairman.  So Bernanke…if you read this…I’ll buy you a beer next time you’re in town.  I don’t know how you sit in front of that panel and answer every question with such professional bearing. 

The Big Picture

The overall tone of the testimony was that things are tough, they will stay tough for a while, the overnight rate has no reason to go up any time soon, and that we can’t sustain long term federal deficits that are several times our annual GDP.  There are more voices clamoring for fiscal restraint recently but it doesn’t have a feel that anyone is remotely close to reigning in spending.

The Market

The bond market is unchanged on the short end and up a bit from the 10 year out.  The 10-year is currently trading at a 3.66%. 

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

Steve Scaramastro, SVP

800-311-0707

 

FW: Market Update 2 19 10 _ Dinner with a Fed President

A few nights ago the wife and I were synching our schedules for the rest of the week and I mentioned to her that I had a dinner meeting Thursday evening.  She glanced my direction and asked “oh, is this the thing with your little nerd group?”  The Economic Club of Memphis…yes…my “little nerd group”.  Its times like these that I really understand how Rodney Dangerfield must have felt.  She’s a bean counter anyway so I don’t know where she thinks she has a lot of room to be calling me a nerd.

So last night I had dinner with the Memphis Economic Club.  The guest speaker was James Bullard, President of the St. Louis Federal Reserve Bank (voting member).  The prepared notes to the meeting were fairly bland and best summed up by a friend of mine when he said the speech could be divided into three parts:

1 – The history of the Fed

2 – The “It’s not our fault” section

3 – The “We need more oversight powers to keep this from happening again” section

The main presentation seemed to be a PR campaign to educate people on where the Fed came from, how they do what they do, and how they helped rather than hurt the economy as we moved through this crisis.  One surprising fact in the presentation dealt with the extent to which the Fed is audited.  By the Feds estimation they undergo roughly 425,000 hours of audit on an annual basis.  This includes their internal auditors, Deloitte (their external auditors) and Board of Governors oversight.

If you could ask one question…

The Q&A session, as usual, was far more informative than the main presentation.  My question to Bullard was “given the current state of the “recovery”, when, how fast, and how high do you see the Fed raising the overnight rate?”  Based on daily conversations with bankers I knew this question was on your minds, so I went with that.

Bullard stated that in his view the market’s perception that the Fed Funds rate is going up later this year is “over blown”.  He goes on to state that they have two instruments on the table...the short term rate and quantitative easing, which gives them a degree of flexibility when it comes to executing any monetary policy tightening.  They could move the short term rate “off zero” or adjust the quantitative easing to get the monetary tightening effect that they are after.  His view is that markets get overly focused on interest rates…but they could tighten just as easily through quantitative measures instead. 

As is perfectly reasonable he answered all questions against a backdrop where the data drives the decisions.  There is no set plan that they will execute in a prearranged order…they have the flexibility to move in any direction they deem appropriate given the tone of the economic data as we move forward.

What’s that on your balance sheet?

Bullard spoke of the Feds 1.25 Trillion dollar position in MBS like it was no big deal.  He says that they’ll be done with their purchase program in March, and that they’ll be able to just sell MBS out of that position when they want to.  Listening to him speak you’d get the impression that this is no big deal...like there was nothing that could possibly hinder their plans.

He and I don’t see that program, nor it’s unwinding in the same light.  In his view they will just unwind it at their discretion.  In my view the market has just as big a say in how and when they end as they do. 

On Unemployment

Bullard received a question on whether the Unemployment Rate can return to its long term levels around 4%.  He stated that he thinks it can return to those levels over time but that it will “not happen very soon.”  He expects the Unemployment Rate to tic down but sees no dramatic improvement anytime soon.  Bullard also pointed out that while the flexibility of our labor force and structure allows us to generate very low unemployment rates it takes time for this to happen and that it will be a painful and difficult process.

That’s it.

So those are the highlights from dinner with my little nerd group.  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

 

Market Update 2 10 11 _ Prepay Tsunami coming for Freddie pools in Feb

Let the buyouts begin

 

Freddie Mac has issued a press release this morning detailing their plans to purchase delinquent loans out of pools starting this month.  As I read the press release from Freddie Mac and try to picture what is really going on behind the scenes I’m reminded of a tense scene from the movie Jurassic Park.  There was a point in the movie where the computer system that helps contain all of the dinosaurs in the safe area had to be rebooted.  There were serious concerns regarding the safety of this operation but it was viewed as necessary.  Samuel L. Jackson is the computer guy that will have to hit the button, he’s worn down from the stress, he’s smoking a cigarette, and in a gesture half filled with surrender and half filled with frustration, hit’s the reboot button and mutters “hang on to your butts people.”  This press release has the same feel.

 

The idea at this point is to pull out all loans that are 120 days delinquent.  You might be asking something along the lines of “why wouldn’t they do that anyway?”  The answer is that Freddie guarantees timely payment of P&I on the mortgage pools.  One way to do that is to just use capital to keep the loans current…basically Freddie is paying the note to keep it current rather than paying to pull it out.  The “keep it current” method burns less capital than the “buy the whole loan out” method.  The GSE’s did this extensively during the height of the crisis.  The owner of the security doesn’t care because they get their money on time, every time. 

 

Now however there are new accounting rules in place.  Under the new rules it is reportedly cheaper to buy the non-performing loans out of the pools than to simply keep them current.  Keep in mind that Fannie and Freddie just received unlimited lines of capital from the US Government…they will be able to buy as many loans as they need to buy...they are not limited in any way by capital constraints. 

 

So what does this mean to holders of Freddie MBS? 

 

At a minimum it means you should be looking for a material spike in one-month speeds as Freddie buys a bunch of loans out of the pools.  Every loan they buy will be the equivalent of a refi in the pool.  Word on the street is that they will be more consistent with this process going forward so the big spike should be a one-time event.  However…if they are going to be more consistent going forward I would expect prepays to increase by some amount across the board going forward. 

 

Essentially it looks like they are going to clear a log-jam of stuff they’ve been putting off for a while.  Once they get that taken care of it will be a “clean up as you go” process. 

 

If the new operating plan is to “clean up as you go” then prepays should definitely increase by some amount going forward as the loans will be purchased out as soon as they hit 120 days delinquent.  Will the speed increase be material on an ongoing basis?  Time will tell.

 

 

Where the rubber meets the road

 

The most immediate and concrete impact for holders of Freddie pools will revolve around sales for FEB settle.  There will be a high degree of reluctance for anyone to put a bid on a Freddie pool for Feb Settle since everyone knows that a big spike in prepays is coming.  I’m not saying there will be NO bid for Feb settle…but if you can find one don’t expect it to be wonderful.

 

My mortgage trader is saying that everyone will wait to see what the speeds were, and then bids should come back for March settle. 

 

What about Fannie?

 

Fannie Mae has not yet released such a press release but it is expected to something similar. 

 

Other stuff in the news and rumor mill

 

From a “what’s in the news” perspective this has been a very interesting week.  We’ve recently seen the market take a wild ride on concerns that Greece would default on its debt, only to have that reversed as traders around the world got comfortable with the fact that the EU would step-up and deal with the issues. 

 

We also have Iran in the news promising a big surprise and to deliver a big punch to the west on February 11^th.  In a WWF type move Iran also told Britain they were about to get “smacked in the mouth”… for those of you who’ve never stepped foot inside a mobile home,  own a Lynard Skynard T-shirt, or been to a monster truck show, “WWF” stands for World Wrestling Federation.  If these guys weren’t working on a nuke I’d actually get a kick out of watching them.  So far the Iran news doesn’t seem to have affected the markets much. 

 

Moving on we have China’s military openly calling for dumping US debt as a punitive measure to demonstrate their displeasure with our foreign policy.  There is some scuttlebutt that China is telling its larger institutions to begin selling Asset Backed Securities and Corporates and hold only Treasuries or Agency debt.  I’ve not substantiated this bit of information yet but when my sources in China wake up I’ll see what they know and I’ll let you know if they have anything to add. 

 

Someone in the office commented this morning that there is simply no telling how much money the country is saving due to the fact that a snow storm is keeping everyone in Washington from getting to work.  I couldn’t agree more. 

 

The markets

 

The bond market is fairly quiet at the moment.  The curve is relatively unchanged through the 10-year spot.  The 30-year is up 12 tics.   Stocks are materially unchanged on the day. 

 

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

 

Steve Scaramastro, SVP

800-311-0707

 

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

 

Market Update _ My neighbor fixes cars like the government fixes economies

Economics and turning wrenches

My neighbor Dave bought his son a car recently.  The car is a used BMW and the plan was that they could get some good father and son time while working on it.  The car was having some problems recently so Dave came over to my house to borrow a set of car ramps. The idea was that he’d get the car up on the ramps, get a good look at the problem and then fix it.  About two minutes after he borrows the ramps the neighborhood was filled with the sounds of chaos.  There was lots of shouting and the sound of metal on metal contact…the type of scraping, smashing and grinding that would make survivors of the Titanic cringe. 

After borrowing the ramps Dave drove the car up them and then straight off the back.  At this point his son began screaming “NO NO NO!” as he watched his new chariot (along with his dreams of first dates) come crashing down right in front of him in a horrific show of automotive carnage.

A few minutes later Dave was back.  This time he wanted to borrow my 3-ton floor jack.  OK.  He drags the floor jack over to his house and at some point realizes it’s going to take more than he thought to fix this problem. 

A few minutes later Dave was back…again.  This time he wanted to borrow my jack-stands.  He was now just reaching for solutions.  He didn’t look like a man that was thinking things through…he was in full bore “reaction mode”.  Rather than think through the problem, he was just doing the first thing that came to mind and then dealing with the fallout of that action in the next round.

I haven’t seen Dave since the last round of borrowing but as I worked in the garage last night I glanced over at Dave’s house and chuckled when it hit me.  There are some similarities between Dave fixing that car and the government’s attempts at fixing the economy.  When it was first learned that there was a problem they both decided they could “fix” it.  They didn’t really have the tools they needed though so they borrowed stuff and decided they’d figure it out as they went.  The problems actually got worse once they started trying the fix them, then they got stuck and had to borrow some more, then that didn’t work and they had to borrow still more.  Now they’ve got all of the original problems to deal with plus a few more that they created along the way, and sooner or later the lenders will need their stuff back.

When I left for work this morning he still had car problems and he still owed me a bunch of tools.  I just shook my head as I drove past his house because I knew I’d be seeing the same story play out on my Bloomberg when I got to work…we’re still trying to “fix” the economy and we owe a lot of people a lot of money. 

Recent news

The economic news of the day surrounds the pace of business activity.  The Chicago Purchasing Managers index was in positive territory and beat the estimate, signaling a bit more growth than expected.  The NAPM-Manufacturing numbers behaved similarly, and the Dallas Fed Manufacturing Activity report eaked out a very small increase posting a 0.3% increase vs. an expectation of 0% change.  The market has not moved much this morning on the economic data.  In fact it rallied a bit after those releases, pushing prices a bit higher and yields lower.

 

Much of the news seems to be overshadowed by equity market concerns over the fallout of the Dubai debt situation.  Treasury levels are currently near their recent low-water mark.  The 10-year is trading at a 3.23%...close to the 3.17% level it posted back in October.  MBS spreads remain fairly tight as well with the spread between the 15-yr MBS and the 5-year Treasury running at 126 basis points.  This spread was well over 300 bps at the height of the crisis. 

 

So right now the market is fairly quiet and seems to be awaiting the fallout of both the Dubai situation as well as the Tiger Woods situation.  This morning we were trying to figure out if a

5-iron or a 6-iron is more appropriate for busting out the rear window on an Escalade.  If anyone has the answer to that please let me know because we’re trying to settle a bet.

 

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

 

Steve Scaramastro

800-311-0707