The financial turmoil is not over. The underlying housing situation continues to worsen and the Fed will reduce the funds rate only in a situation that investors won’t like at all. The bad news is continuing to dribble out day by day and will not stop soon. We expect defaults and foreclosures to keep rising over the next year or two as borrowers run into trouble on loans that started out with low monthly payments only to reset later at much higher rates. Investors in credit derivatives have marked their values to models that have failed miserably and are now faced with the prospect of severe markdowns. If funds run by the so-called smartest guys on the block at Goldman Sachs and Bear Stearns have suffered such heavy losses there must be scores of other funds that will be forced to come out of the woodwork as well, and this will make for some dire headlines. As is indicated below the market turmoil is not merely an emotional scare, but is deeply rooted in fundamentals. In the last two days Lehman announced that it is shutting down its unit that issues subprime mortgages, while Accredited Home Lenders indicated that it will stop taking U.S. loan applications. In addition Capital One said it would close its Greenpoint mortgage unit that it picked up when it bought North Fork bank. At least 90 U.S. mortgage companies have halted operations or put themselves up for sale since the start of 2006, and, if anything, the process is accelerating. Challenger, Gray & Christmas reported that since the start of the year 40,000 layoffs have been announced by mortgage lenders, including 25,000 announced just since the beginning of this month. In addition another 20,000 layoffs have been announced by construction companies. The National Association of Realtors said that their membership numbers would decline for the first time in a decade. The FDIC announced the biggest increase in late loan payments in 17 years. Yesterday Toll Brothers stated that tightening mortgage standards would shrink the pool of potential home buyers. CEO Robert Toll said "Mortgage market liquidity issues and higher borrowing rates may impede some customers from closing, while others may find it more difficult to sell their existing homes." He reported the lowest traffic levels and the highest cancellation rate in two decades as a public company. In an interview on CNBC, Countrywide CEO Angelo Mozilo was equally pessimistic about the housing picture. He stated "I don’t see a light here." There is a "very serious situation going on.This environment is certainly not getting any better." Asked if there would be a recession he answered "I think so.I can’t believe that when you’re having a level of delinquencies, foreclosures—equity has disappeared, equity is gone, the tide has gone out—that this doesn’t have a material effect, A, on the psyches of the American people, and eventually on their wallets.I’ve seen this movie before, and the ending of the movie always ends up in some form of recession." In addition John Lipsky, the second highest official at the IMF had something to add about the global economy. Referring to the current market turmoil he said "This undoubtedly will dampen growth.A number of the financial institutions that have been affected most strikingly have not been U.S.-based." He warned that there would be no quick end to the turmoil because of uncertainty as to how much damage it would do to growth, stating "This will create a feedback loop that means it will.take some time for markets to restore a normal amount of volatility. We are finding that in some cases regulated financial institutions are carrying off-balance sheet risks that have indirect implications for the institution." In our view the credit and equity market problems are not based on mere emotion or fear, but are deeply rooted in the fundamental situation. It is increasingly likely that the housing mess will very shortly spread to consumer spending and the rest of the economy. The Fed’s choice of reducing the discount rate rather than the funds rate combined with Richmond Fed President Lacker’s recent speech indicates that the Fed is focusing primarily on boosting confidence and won’t reduce the funds rate until they see a significant growth slowdown in the real economy. If they don’t see such a threat by the September 18 meeting the markets may be shocked if the Fed maintains the current funds rate. On the other hand the kind of negative economic data that would induce the Fed to act would also be highly disappointing to those insisting that we are still in a goldilocks economy. We think that a major bear market has already started and that, despite occasional sharp rallies, the overall trend is down http://www.comstockfunds.com/index.cfm/MenuItemID/29.htm |