On August 15,
the 90-day T-bill rate was 4.21%. The next day it fell to 3.79%.
That was a one-day drop of .42 percentage points. As a percentage,
it was a 10% drop. We rarely see 10% moves in one day. The next
day, Friday, it was down to 3.76%.
August 20, it fell to 3.12%. That was another 17% decline.
This was not
a merely rush for safety. It was bordering on panic.
was not the result of huge injections of new fiat money into the
system. This was increased demand from investors who were looking
for security. The rates dropped all across the Treasury’s yield
curve on the 16th. They fell again on the 20th.
buying T-bills because they know they will be paid off in 90 days.
They are buying T-bonds because they fear recession’s falling rates
more than inflation’s rising rates.
facing the Federal Reserve System today is that an increase of money
to lower the federal funds rate will be seen as inflationary. This
would be a major reversal of policy. Why would the FED reverse policy?
Because of panic at the FED regarding the capital markets. It would
also make it look as though Jim "Mad Money" Cramer is
calling the shots for the FED. Its announcement came just ten days
after Cramer threw his tantrum on CNBC. Admittedly,
it is worth watching.
The FED’s announcement
of the drop in the largely irrelevant discount rate from 6.25% to
5.75% immediately sent long-term rates back up — not by much, but
opposite to the move in the 90-day rate. That announcement was perceived
as announcing future monetary inflation to lower the FedFunds rate.
Long rates went up because of an inflation premium demanded by investors.
This was reversed
in one day: August 20. Investors feared a liquidity crisis.
The move to
Treasury debt does not bode well for the mortgage market. It is
the perceived lack of safety of the subprime end of this market
that has created a crisis for mortgage-based securities generally.
or disappearance of over 130 mortgage-lending institutions since
late December is calling into question the equity of the housing
markets generally. (This is tracked by the Implode-O-Meter site.)
This pushes lenders to require 20% down. Borrowers are supposed
to have capital to invest. But where does a borrower get 20% down
today, with the median-price house at $225,000? From the profit
from the sale of his existing home. But the equity from this home
is falling because of the mortgage lending crisis.
announced on August 20 that it will skip offering any mortgage-backed
debt in August. The spokesman did not say how long this ban will
be in effect. He did not elaborate. But the financial press understands
the reason. Investors have decided not to invest in this capital
market except at rates too high for Fannie Mae to attract solvent
What went up
is now coming down. You had better get out of the way.
MONEY SLOWLY, AND LOSING IT FAST
popular belief, most people do not want to make money. They want
to make money their way.
leads to losses when markets change direction. Investors stick with
portfolios that are becoming defunct. The want the market to confirm
their genius. The market, like Rhett Butler, really doesn’t care.
It takes substantial
financial losses to persuade a typical investor to sell his battered
investment portfolio and try to make his money back with whatever
capital he has remaining. He has to abandon his way for the market’s
way. This is very costly for most investors. Few do it in time.
expensive process of self-realization, an investment market becomes
volatile. Most people resist selling their positions. So, the market
is pushed and pulled wildly by marginal sellers and marginal buyers
until such time as the new direction of the market is clear. If
it is downward, the last hold-outs finally surrender and sell at
the bottom. In the meantime, they sustain significant losses. In
recent years, the NASDAQ has been a good example of this, from March
2000 to October 2002. The slow move up to 50% of its high was far
less volatile than the fast move down. See
stock markets have become increasingly volatile ever since June,
can see the various U.S. stock markets here.
On July 20,
the Dow Jones Industrial Average closed above 14,000 for the first
time. The next day, it fell by 150 points. From that point on, the
market lost 1,000 points, but not in a straight line. You can see
this roller coaster ride by clicking through to the
AT THE MARGIN
occurs when a relatively small group of investors at the margin
change their minds about the future of a class of assets. They decide
that the market they had invested in now faces risks which they
did not previously perceive. So, they sell.
investors at the margin see what they believe are new profit opportunities.
They have not yet changed their minds. They buy the asset class
because they believe that the previous sellers are incorrect in
their revised assessments. They believe that the forces that propelled
the asset class upward are still dominant. They decide to take advantage
of the sellers, who were overreacting. They buy.
At this point,
the future of the market is dependent on whose minds get changed:
the sellers or the buyers.
this debate takes place at the margin of an investment asset class.
The vast majority of investors are in the market through the decisions
of third parties: managers of funds, banks, insurance companies,
and similar specialty firms in asset allocation. These managers
cannot all sell their asset base at one time. The entire capital
market would collapse if they tried. They can sell only a small
percentage of these assets. The question is: To whom?
The best and
brightest of the corporate asset managers trained in the same two-dozen
universities and dozen graduate schools in business. They received
the same worldview. They adopted the same views on capital, monetary
theory, and government intervention. To a person, they are believers
in central banking as the supreme stabilizer of erratic capital
work as the third parties for American investors and also foreigners
who have invested in the United States. They are an occupational
class. But they are more than this. They are a social class. They
read the same magazines, travel in the same circles, and communicate
with each other.
They are a
I recall a
column in the Wall Street Journal, "Heard on the Street."
It should have removed the letter "a."
ago, Harvard’s left-wing economist John Kenneth Galbraith made this
observation: "Genius is a rising market."
sometimes fall. Geniuses are then exposed as something less than
is, they really are the best and the brightest. They attended the
best graduate schools. They graduated in the top 20% of their class.
They were recruited by the richest multinational banks and brokerage
houses. Then they spent a decade or more competing against each
other in the capital allocations markets. The survivors run the
Then the market
a crisis of confidence among investors. But what can they do? They
can sell one asset class and buy another. But which one? Where will
they obtain advice? From a different management team. But these
managers are basically clones of the others. They differ only at
You can see
the problem. This is why asset classes move in the same direction
for years, even decades. The stock market went up from August 16,
1982 to mid-March, 2000. Then it reversed, falling until 2003 and
never recovering to its inflation-adjusted level of 2000.
who ran the large institutions have not yet lost the trust of investors.
Investors still allow their retirement portfolios to be run by the
Establishment managers. These people are operationally cheerleaders
of the Federal government. They cheer about the supposed 7% per
annum increase in the stock market, despite the fact that it is
down from 2007. They remain deathly silent about the looming deficit
in Medicare and the smaller one in Social Security. Jointly, the
two programs are in the hole by at least $60 trillion.
are geniuses by default.
Now they face
a huge public relations problem. The three firms that rate the risk
of corporate debt — Moody’s, Standard & Poor’s, and Fitch —
failed to see what would happen to an entire asset class: mortgage-backed
securities and the spin-off products. They did not sound a warning
in 2005 and 2006, when the mortgage industry lent close to half
of its loans to subprime borrowers who would not have qualified
for loans in 2000. Worse, they allowed these people to borrow at
floating interest rates: ARM’s.
At least 80% of the subprime loans in 2005—6 were ARM’s.
I began warning
against ARM’s in the
July 22, 2003 issue of Reality Check.
In the February
21, 2006 issue, I
escalated my warning.
another looming disaster facing the banks: the end of the housing
boom. The last three years of the housing boom have been funded
by ARMs: adjustable rate mortgages. Marginal home buyers have
taken advantage of super-low mortgage rates. Now the days of wine
and roses are ending. As short-term rates climb ever-higher, home
owners’ monthly mortgage bills threaten to double. Conclusion:
There will be a rising tide of defaults by ARM home buyers.
The FED wants
an orderly real estate market. It wants lower long-term mortgage
rates, so that there will be buyers of the distressed properties
that are put on the market by ARM buyers who cannot afford to
make their mortgage payments. You might call these sellers ARMed
and dangerous — dangerous to the banking system.
is now here. The subprime mortgage market has now begun to unravel.
These loans have become unsalable. The professional ratings agencies
did not sound an alarm. No one knows what these loans are worth,
so institutions holding them are unable to sell them to other institutions.
Who owns these
mortgages? I asked my former partner John Mauldin if he had any
figures, since he had just written a report on it. He sent me Chart
44 from A. Gary Schilling’s Insight for January, 2007. The
chart is for "Mortgage-Related Securities Holdings by Investor
Type." The numbers are in trillions of dollars. The total was
$5.4 trillion in 2006. Here is the breakdown.
- 18%: FDIC-insured
- 4.5%: thrifts
- 1.3%: Federal
- 21.7%: FNMA
("Fannie Mae") and FHLMC ("Freddie Mac")
- 15.5%: foreign
- 7.8%: mutual
- 6.8%: personal
- 5.5%: insurance
- 3.5%: public
- 3.1%: private
- 2.7%: real
estate investment trusts
- 2.4%: Federal
home loan banks
- 1.8%: securities
- 6.9%: miscellaneous
This is a cross-section
of the investment community, with Fannie/Freddie, banks, and foreign
investors being the three most committed groups: over half.
The mania affected
all of these groups. They all saw tremendous opportunities for profit
here. This is what happens when the Federal Reserve System inflates.
It creates booms that become self-reinforcing.
bubbles pop. When all members of the class of geniuses discover
that the assets at the margin are no longer salable, this calls
into question the genius of the asset managers regarding the portfolio
as a whole.
There is a
basic law of equity: "When liquidity falls, equity falls."
Liquidity is falling, though not yet collapsing, as a result of
the subprime loans, which are at the margin of the mortgage-based
of liquidity keeps entry-level buyers from buying. It therefore
keeps recent purchasers from selling at anything like the debt obligation
they incurred. They have no equity.
comes if one of them loses his or her job. There will be a default.
When interest rates rise next year because of the re-set provision
of their mortgages, they will find that they cannot meet the monthly
This does not
bankrupt every home owner, by any means. But when the glut of unsold
foreclosed houses hits in 2008, the price of entry-level homes will
fall. This new, lower price structure will be applied to all homes
in the price class. Everyone’s equity will fall in this price class.
This will create a reverse bubble effect.
If genius is
a rising market, what is a falling market?
There is nothing
like a forest of "For Sale" signs to create a batten-down-the-hatches
mentality among home owners. These home owners are consumers.
the question of reduced consumer spending. This is well known now.
It was not discussed by the mainstream media a year ago. A year
ago, the geniuses were in the saddle.
to the FED’s announcement of a lowering of the inconsequential discount
window rate, the Dow shot up by 300 points at the opening on August
17. Then it surrendered over 200 points before noon. Then it climbed
back for a gain of 223 by the end of the day.
This is volatility.
The geniuses who run the funds are still bullish, but enough of
their investors have redeemed shares and moved to Treasury debt
and money market funds that fund managers have had to sell.
In a time of
spreading uncertainty, volatility precedes a decline in the stock
market. We have seen great uncertainty regarding the subprime mortgage
market. This might have been taken in stride except for the fact
that the ratings agencies did not sound the alarm years ago. They
kept giving high ratings to firms that have gone belly-up. An entire
industry sector was overpriced because of this. Now, the investing
public has seen the truth: the ratings agencies are part of the
"What else have they overlooked?"
GENIUSES AT THE FED
Reserve System has steadfastly maintained that inflation-fighting
is its number-one priority. This has been true since approximately
1933. Bernanke has been adamant about this.
Then the Dow
lost 1,000 points. Lo and behold, this drop of less than 10% brought
new insight to the Federal Open Market Committee (FOMC), which decides
how much debt to buy and therefore how much fiat money to inject.
In the announcement accompanying the discount rate drop, the FOMC
jargon-filled PR statement. It was one paragraph. Let me translate
out it from the original FedSpeak.
the restoration of orderly conditions in financial markets,
are disorderly. They have been disorderly. We are beginning to worry
about a stock market crash."
Reserve Board approved temporary changes to its primary credit
discount window facility. The Board approved a 50 basis point
reduction in the primary credit rate to 5-3/4 percent, to narrow
the spread between the primary credit rate and the Federal Open
Market Committee’s target federal funds rate to 50 basis points.
we keep a one-point spread. By lowering this to half a point, we
are letting troubled banks know that they can get money from us
when they can’t get it from other banks, which smell trouble and
refuse to lend to them."
is also announcing a change to the Reserve Banks’ usual practices
to allow the provision of term financing for as long as 30 days,
renewable by the borrower. These changes will remain in place
until the Federal Reserve determines that market liquidity has
liquidity is in the pits. And why not? The FOMC cut the expansion
of the monetary base in the month Bernanke took over: February,
2006. We have been fighting price inflation, sort of. Now we are
going to fight a credit crunch. We did not see this coming."
are designed to provide depositories with greater assurance about
the cost and availability of funding.
is merely a symbolic gesture, of course. Hardly anyone ever borrows
at the discount window. But depositories — read: banks — need reassuring
that we are not pigheaded about inflation-fighting. We are willing
to reverse course. Maybe. We aren’t making any promises."
Reserve will continue to accept a broad range of collateral for
discount window loans, including home mortgages and related assets.
wants this junk, so there is a liquidity problem facing the mortgage
industry. Bankers made these foolhardy loans, and now they are facing
losses. The FED’s number-one reason for existence is to bail out
really bonehead moves by bankers. This is a whopper."
collateral margins will be maintained. In taking this action,
the Board approved the requests submitted by the Boards of Directors
of the Federal Reserve Banks of New York and San Francisco.
bubble has been huge in California and New York City, so we are
not surprised that panic is hitting bankers in these regions."
to see continuing stock market volatility. The post-2003 geniuses
are facing a challenge by investors who see what a mortgage credit
crunch can do to the economy. There is a tug-of-war going on.
If you own
stocks, you’re in the middle of this tug-of-war. You had better
decide soon who is going to win it, and why. If you wait for the
market to confirm your assessment, you risk losing a bundle or else
failing to make a bundle.