A Panic Move to Buy Safety

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%.

On Monday, 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.

This decline 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.

People are 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.

The problem 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.

The bankruptcy 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.

Fannie Mae 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 home-buyers.

What went up is now coming down. You had better get out of the way.


Contrary to popular belief, most people do not want to make money. They want to make money their way.

This preference 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.

During this 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 for yourself.

The world’s stock markets have become increasingly volatile ever since June, 2007. You 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 following chart.


Volatility 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.

Then other 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.

Understand, 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 markets.

These people 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 herd.

I recall a column in the Wall Street Journal, “Heard on the Street.” It should have removed the letter “a.”


A generation ago, Harvard’s left-wing economist John Kenneth Galbraith made this observation: “Genius is a rising market.”

Problem: markets sometimes fall. Geniuses are then exposed as something less than geniuses.

The problem 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 firms.

Then the market falls.

This produces 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 the margin.

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.

The geniuses 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.

These people 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.

There is 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.

The crisis 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 banks4.5%: thrifts 1.3%: Federal credit unions21.7%: FNMA (“Fannie Mae”) and FHLMC (“Freddie Mac”)15.5%: foreign investors7.8%: mutual funds6.8%: personal sector5.5%: insurance companies3.5%: public pension funds3.1%: private pension funds2.7%: real estate investment trusts2.4%: Federal home loan banks1.8%: securities brokers6.9%: 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.

But eventually 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 securities market.

This reduction 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.

The problem 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 mortgage payment.

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.

This raises 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.


In response 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 herd.

Investors think: “What else have they overlooked?”


The Federal 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 released a jargon-filled PR statement. It was one paragraph. Let me translate out it from the original FedSpeak.

To promote the restoration of orderly conditions in financial markets,

“Markets are disorderly. They have been disorderly. We are beginning to worry about a stock market crash.”

the Federal 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.

“Usually, 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.”

The Board 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 improved materially.

“Market 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.”

These changes are designed to provide depositories with greater assurance about the cost and availability of funding.

“This 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.”

The Federal Reserve will continue to accept a broad range of collateral for discount window loans, including home mortgages and related assets.

“Nobody 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.”

Existing 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.

“The housing bubble has been huge in California and New York City, so we are not surprised that panic is hitting bankers in these regions.”


Expect 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.

August24, 2007

Gary North [send him mail] is the author of Mises on Money. Visit He is also the author of a free 19-volume series, An Economic Commentary on the Bible.

Copyright © 2007

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