The Economy

Rate Watch #610 I'll See you $30 Billion and Raise You $200 Billion

March 21, 2008
by Dick Lepre
dicklepre@rpm-mortgage.com
www.loanmine.com

IV) Analysis

The Treasury market is volatile which 1) makes forecasting difficult and 2) creates opportunities. I do believe that this is not going to be a case of constantly declining rates but one of a relatively brief window of opportunity. I say this because we are coming to the end of the secular bull market (long-term trend to lower yields) but the facts are that this is an extremely confusing time and there is a disconnect between Treasuries and mortgage rates. Mortgage rates could start getting lower even if Treasury yields rise.

There is still lack of clarity about the pricing and terms of the new jumbo-conforming loans. The biggest news this week was that FHLMC will do cash-out on these (whereas FNMA will not). Preliminary indication from FHLMC is that the requirement on cash-out jumbo-conforming are: LTV <= 75% and middle credit score >= 720. This is available for primary residence SFR & condo. No multifamily.

You can find the new conforming limit for your county here. That page says "FHA" but those amounts also pertain to FNMA & FHLMC.

If you have a loan which is now conforming as long as it is not a cash out or as long as it meets the FHLMC standards above and are interested please e-mail me or fill out a refi form on my web site. Once I get that I will contact you, discuss what you need and in less than 10 minutes I can take your loan application over the phone. What do I need? The most common things which people do not have at hand is their spouse's social security number and their gross monthly income,

The complete application is accessed from the top right nav bar at www.loanmine.com.

V) Things Are Happening

A lot has happened in the past few weeks regarding which I would like to comment.

1) The Bear Stearns thing. This is most interesting. It represents a daring move by the Fed to accomplish its main purpose which is economic stabilization. Bear was deeply into subprime and clearly had assets which were worth a lot less than folks though. The Fed brought in potential buyers and faced with the necessity of opening its books up it is clear that Bear was exposed a lot more than it had implied. One can figure this out from the fact that JP Morgan's offer was 7% of what the Bear stock closed at on Friday March 14.

In a bigger sense what this is about is the fact that Wall Street firms (primary dealers) act like banks in the sense that folks keep a lot of their liquid assets (which used to be in banks and S&Ls) in accounts with security firms. The Fed's guaranteeing the debt of a non-bank entity really recognizes that for decades it has been the case that the concept of banking was no longer the same. The collapse of one of these firms or even the suggested collapse and the run on its assets was not different in kind and in effect from a bank run.

The important point is that while I often talk about the goals of the Fed (low interest rates, increasing GDP, strong dollar etc.) those goals are less important that the Fed's main task which is stability of the banking system. It is only at time such as the present that this is a goal not to be taken for granted.

Comments that the Fed was somehow "bailing out the rich" while not paying attention to the little guy are inane. The stockholders of Bear were screwed. The people who were bailed out were 1) anyone with a Bear Sterns account and 2) anyone with deposits in any similar Wall Street firm and, to some extent, anyone with deposits in any bank. It is conceivable albeit unlikely that a run on Wall Street firms could set off runs on counterparty banks and then set off runs on those banks.

The point is that if folks decide on a massive scale to take their money out of wherever it is - be in a Wall Street firm, a commercial bank or an S&L the economy will grind to a halt.

The perceived safety of having ones assets in one of these place is the primordial purpose of the Fed.

It has also been suggested that actions such as this or the LTCM bailout in 1998 encourage dangerous practices. Maybe they do but similar logic would indicate that fire departments and insurance companies serve to encourage people to be less careful that their houses do not catch fire. The Fed is like the fire department. They show up in a big way when things go wrong but acting to abate disaster does not per se encourage dangerous practices. The stockholders, employees and executives of Bear Stearns took a beating and the Fed's actions will in no way encourage similar behavior in the future.

It is my belief that once "the dust settles" folks will recognize that having an independent Federal Reserve to adeptly handle the monetary part of federal policy works quite well. Political processes (the fiscal side) take too long to deal with fires. The Federal Reserve is not merely about one guy or even the Governors it is a large collection of economists with a great deal of experience and no political agenda.

As for Bear Sterns the story is truly amazing. Here was one of the firms as the center of the subprime mess and they clearly massively underestimated the risks of the subprime loans they were pushing. There is indeed a sense of justice operating here.

2) the liquidity thing. The Fed offered to provide $200 billion in liquidity by exchanging its Treasuries for MBS of primary dealers. This creates liquidity because those MBS are, at present, illiquid and the Treasuries are liquid. The Fed is to some extent sticking its neck out here by tying up a larger percentage of the Treasuries which it owns but it is doing this for a good reason. This is not mere talk. On Wednesday alone the Fed provided $28.8 billion in lending to primary dealers through this channel.

3) the bigger picture. I suppose that the big picture is reestablishing belief in mortgage backed securities. To some extent the fact that FHLMC & FNMA doing jumbo-conforming this is obviated but banks will eventual want to get back into the mortgage business.

Getting refinancing in place to lower the payments of folks who have ARMs will help to stimulate the economy and getting mortgage rates lower will help to stabilize home values. I still believe that home values will trend downwards for at least another year but the mechanisms for stabilizing the entities that will make those loans have been recast. Housing prices ran up because of unhealthy speculation combined with idiotic lending. The idiotic lending has stopped but it will take time for the demand to catch up with the supply. No act of Congress or Fed intervention will change that.

If you are interested please e-mail me or fill out a loan application or refi form on my web site. The complete application is accessed from the top right nav bar at www.loanmine.com.

If you have something to add to this discussion please post a comment on the blog.

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Dick Lepre
RPM - SF

What the Fed Is Up To

This past week Treasuries saw some serious selling after the FOMC minutes indicated that there was a substantial risk that inflation may not recede as expected and noted they must ensure it slows. The statement has about as much original content as notification that the sun rises in the East. Has the Fed ever said, "Inflation? No problem, don’t sweat it. We got it covered." In fact the Fed is merely putting the word out that unless inflation is contained to its satisfaction it may not lower rates as the market participants wanted/expected.

The underlying fact it that it is amazing that the Fed can exert so much power as it does not by changing rates but by taking an attitude to changing rates. Years ago the Fed "ran the economy" by adjusting money supply. That, intuitively, seemed real. Lower the money supply and less stuff get bought and inflation slows. But the Fed no longer has any meaningful control of the money supply. I have written about this before. Much of the money supply is outside the control of the Fed's reach over the banking system and the massive amount of credit availability through credit cards and HELOC’s creates buying power.

The Fed's ability to control the economy by regulating one interest rate on something that does not get used anyway (banks do not really borrow from the Fed window; they borrow from other banks) is impressive, The Fed, in effect, controls prime and interest rates up to 2 years. It is only the perception of the containment of inflation that keeps longer term rates in check.

Part of the reason why the Fed is so effective is that it is outside the control of politics or politicians. The forces which control what people say or do to get elected or reelected do not induce people to make wise fiscal choices. In fact, politicians have little to do with the ups and downs of the economy. They merely use them to take credit or ascribed blame to their opponents.

The market's present reaction to the Fed is yet another example of how players try to induce the Fed. Clearly it was the case that the amount of buying in the latest week-to-week bull cycle was based on a belief that the Fed would ease sooner rather than later. The FOMC simply said, "No, thank you. We are still concerned about inflation and, guess what, we control interest rates not you."

I do not believe that the Fed's words should to any great measure be construed as a warning that inflation is about to break out. The Fed is 1) being cautious and 2) serving warning that business must not allow CPI to move up if they want lower rates.

The pieces are in place for inflation containment: 1) lower energy prices 2) very high corporate profits allowing companies to absorb wholesale price increases and wage increase without passing the cost to CPI (the consumer) 3) flat housing prices will translate into less construction and lower costs for building materials and all that stuff that Home Depot sells.

Strangely, we see little concern about higher wages caused by a tightening labor market. To some extent this merely reflects the nature of the media. By classic standards we have such a low unemployment rate that we should be seeing wage inflation but just as in the 1990's wage increases remain modest. Contained wages are likely the result of 1) globalization and 2) weakened labor unions. The notions of nominal wage, real wage and employee compensation have been blurred by workers getting higher compensation in the form of the increased cost of medical benefits.

The Fed

The folks who framed the Constitution drew on the experiences of European governments and formulated a 3 part federal government: the president, Congress and the courts. A system of checks and balances" among the 3 branches is supposed to prevent any one of them from becoming too powerful.

There are times when it is obvious that this system functions. Bush cannot wage war without the support of Congress. Appointments to the Supreme Court are nominated by the President but go through what appears to be an agonizing introspection by the media, those with political agendas on both sides and the Senate.

In many countries the military has the real power. This seems to work in smaller countries but in the US the military wields no substantial political power.

Like it or not, there is one pervasive power in the US - money.

Money is brought to you by the Federal Reserve. The Fed functions in a manner to make it something akin to the 4th branch of the government. The Chairman of the Federal Reserve, Alan Greenspan, has on his desk a sign saying "The Buck Starts Here".

Greenspan's replacement has been nominated. He appears to be a well-studied and competent person for the job. Let's review what the Fed is all about.

The Federal Reserve was created in 1913 see: http://landru.i-link-2.net/monques/FR1.html to provide, duh, a Federal Reserve - a way for banks to share each others' reserves if there was a "run" on one. After the Depression, Congress, in 1935, created the system whereby the Fed was able to create money by purchasing government securities. When it did that, it probably did not understand how important that decision was.

The Fed controls business and the economy by controlling the money supply and by its ability to control interest rates by buying and selling government securities on the open market. More
impressively, the Fed can send shock waves through the economy by merely talking about raising rates. The rate that the FOMC sets is the "target" for the Open Market yield of the 30-year Treasury bond. It is maintained not by edict but by persuasion and a active participation by the Fed itself in the market. It is, in effect, engaging in price fixing - perhaps "price control" would be a gentler term.

The "deterrent" force of Greenspan's mouth is akin to the nuclear deterrence of the '50's and '60's. The threat of raising rates has as much effect as actually raising rates.

In recent years that power had been mitigated by the run-up in equities. Real disposable wealth (i.e. money) was created. The Fed was unable to regulate the supply of this "money". To a significant extent, comments by Greenspan during 2000 served to "talk down" equities. Equities have been more "under control" sincethose comments. This is by design as much as anything else.

The Goals of the Fed

The Fed has the following goals: keeping GDP growing, keeping interest rates low, keeping inflation low, helping job growth, and keeping the dollar valuable. By nature, it is not always possible for the Fed's actions to benefit all four goals simultaneously. At present, the emphasis is on inflation.

What Powers Does the Fed Have?

The Fed has 2 main sources of power: 1) the power to "diddle with rates" both by resetting the actual Fed Funds target or by merely talking about it and 2) the "magic checkbook" whereby the Fed can create money out of nowhere and buy bonds on the open market. The power to create money out of nowhere (so called, "fiat money") is impressive. I'd like to be able to do that.

It is imperative that the Fed buy debt on the open market and not directly from the Treasury Department. This idea of "open market" is extremely important. The Fed can open up its checkbook (the magic one with the near infinite overdraft protection) and inject money into the economy by buying government notes and bonds. But, it must do so on the open market. Congress' sovereignty over expenditure is maintained by forcing the Fed to buy from private holders of government debt. If the Treasury Department ran the show, Congress would have succumbed its budget powers to the executive branch.

So What?

The Federal Reserve has very significant control over the economy. But it does not "make or break" the economy. It smoothes out the sizes of the economic cycles by avoiding potholes.

The Fed has looked so good lately because inflation has remained contained. With inflation contained, the Fed has the ability to "fine tune" rates and look great. Contained inflation is like driving down the highway on a clear, sunny day with dry pavement and little traffic. Everyone drives well. If inflation is out of control, the corrective forces of the Fed are like someone trying to avoid other cars on a wet road, at night with a 45 mile an hour crosswind. There will be some wrecks.

The success of the economy of the '90's was not due to politicians or even the Fed. It is due to the combined sanity of workers, businessmen, investors and the Fed. It is very easy for bankers
to make a lot of money and the Fed to look great in this environment.

The Fed has power in its ability to create money. But it has not created wealth and prosperity. Wealth is the product of hard work, a healthy measure of greed and a good bit of luck.

The Real Power of the Fed

I think that, in final analysis, the Fed is one big bank. It can create money but unlike other banks it operates with almost no control from other parts of the government. It is not subject to the audits that other banks are. (The Fed is audited by the GAO and the district branches are subject to outside audits but the audits do not look into the policy making, open market operations or discount window operations.) It is relatively free to buy and sell gold and US and foreign bonds and currencies. It is the lack of intervention from politicians that enables the Fed to work and gives it power. The Fed has served itself well by not causing any scandals - no Michael Milkens, no Espys, no Scotter Libby, no Chappaquiddick, no Oliver Norths.

Transparency. Rational Expectations. Taylor Rule

Fed nominee Bernanke appears to intend that the Fed make one change from its present "style." He is a greater believer in transparency. He appears to intend to tell the markets precisely what the intentions of the Federal Reserve are. This is a departure from Greenspan who love to cloak his intentions with words. Instead of "The Buck Starts Here" sign currently on Greenspan's desk he should leave an "Eschew Obfuscation" sign for his successor. Bernarke is a believer in inflation targeting. Bernarke will not have the ability, at least for some while, to affect the markets the way Greenspan does. Greenspan earned that ability with adept management over a prolonged period.

In a sense, he is part of a new generation of economists. These are folks who believe that the economy works best when all participants has as much knowledge not merely of actual data but also of the intentions of other market participants.

Rational Expectations

Economics was, until the 1960's and 1970's still dominated by the thinking of John Maynard Keynes. Keynes saw the economy as acting as if forces akin to the laws of physics ran the show. There were rules. In the 1970s the rational expectations school challenged Keynesian thought. The rational expectations hypothesis was an expression of freedom. It postulated that people change their behavior when they expect economics policies to change.

To an extent rational expectations theory has been enhanced by information systems such an the Internet. Folks now have access to vast amounts of economic information. They have access to thousand of sources of opinion (such as this newsletter). They have also been given hope by government intervention intended to keep all of the actors honest. Obfuscation of earnings data has a price.

Rational expectations seem to work best in financial markets rather than, for example, the market of business and labor. Financial markets have more flexible pricing and elasticity (for a discussion on elasticity see: RateWatch #421 Elasticity of Supply & Demand). Markets which lack elasticity can suffer. For example, if everyone starts acting not on fundamentals but on what they think the other players are thinking then disaster can ensue. That is what bubbles are about. People did not but dot-com stocks in the late 1990's because they thought that the fundamentals of those companies were sound (as in future earnings). They bought them based on what they though other people thought about those equities.

Another way to look at rational expectation theory is that it is the opposite of Texas Hold 'em. Success at poker comes from not letting the other actors know what you cards are and, moreover, not letting them know what your strategy is. That might be a description of the way business and the banking system functioned in the early 20th century before the Fed even existed.

Rational expectations have a better place when they are used to determine practical policies such as monetary policy. This is why something such as the Taylor Rule works. All of the actors on the economic stage, under the direction of the Fed understand that policy decisions such as raising the Fed funds rate are moving the economy in a direction which will be for everyone's mutual benefit.

Some pieces on Rational expectations can be found at:

http://www.econ.brown.edu/fac/Peter_Howitt/working/Middlebury.pdf

and at http://www.stanford.edu/~johntayl/Papers/IEALecture.pdf

We often talk about the role and intentions of the Fed. Commentators muse about what the Fed is going to do but the fact may well be that the actions of the Fed are fairly predictable and in fact obey a formula. The one paid most attention to is called the Taylor Rule.

The Taylor Rule

The Taylor Rule is named for Dr. John B. Taylor a professor of economics at Stanford. The Taylor rule is an attempt to formalize how the Fed moves the overnight rate in response to the measurement of two key things 1) inflation and 2) GDP growth. Recall that the assignment given to the Fed is: "Keep the economy growing at a moderate pace while keeping inflation low.

A scholarly presentation of this is available in Acrobat format at http://www.frbsf.org/econrsrch/econrev/98-3/3-16.pdf A somewhat more readable version is at http://www.frbsf.org/econrsrch/wklyltr/wklyltr98/el98-38.html We will present here the Lepre skinny view.

The Taylor rule is best regarded as a scientific explanation attempting to quantify the behavior of the Fed by postulating a mathematical equation of the Fed's "reaction function". That is, if one analyzes the data: interest rates, inflation and GDP can one determine a rule that describes the Fed's behavior.

The specific and simple rule is based on the following
r = the equilibrium real fed funds rate (the "natural" rate that is consistent with full-employment)
I = the average inflation rate for the past 4 quarters (note here that inflation is not CPI but the GDP deflator - this was discussed in RateWatch #147)
I* = the target inflation rate
y = the output gap (100*(real GDP - potential GDP)/potential GDP)

The equation is Fed Funds Rate = r + I +0.5(I-I*) +0.5y

If, for example, the target inflation rate was 2% and inflation (as measured by GDP deflator is 3%) then the Fed funds rate should be 2 + 3 + 0.5(3-2) = 5.5%.

In addition, if there is an output gap i.e. a difference between real GDP growth and "potential" GDP growth (a somewhat elusive concept) rates must be adjusted accordingly. If GDP growth exceeds "potential" then rates must be increased.

In practice there are several major considerations. The Fed reacts to the data slowly by adjusting the overnight rate slowly. The goal is the goal legislated for our monetary policy - stable prices and full employment.

The Taylor Rule is named for Dr. John B. Taylor a professor of economics at Stanford. The Taylor rule is an attempt to formalize how the Fed moves the overnight rate in response to the measurement of two key things 1) inflation and 2) GDP growth. Recall that the assignment given to the Fed is: "Keep the economy growing at a moderate pace while keeping inflation low.

A scholarly presentation of this is available in Acrobat format at http://www.frbsf.org/econrsrch/econrev/98-3/3-16.pdf A somewhat more readable version is at http://www.frbsf.org/econrsrch/wklyltr/wklyltr98/el98-38.html We will present here the skinny view.

The Tailor rule is best regarded as a scientific explanation attempting to quantify the behavior of the Fed by postulating a mathematical equation of the Fed's "reaction function". That is, if one analyzes the data: interest rates, inflation and GDP can one determine a rule that describes the Fed's behavior.

The specific and simple rule is based on the following
r = the equilibrium real fed funds rate (the "natural" rate that is consistent with full-employment)
I = the average inflation rate for the past 4 quarters (note here that inflation is not CPI but the GDP deflator - this was discussed in RateWatch #147)
I* = the target inflation rate
y = the output gap (100*(real GDP - potential GDP)/potential GDP)

The equation is Fed Funds Rate = r + I +0.5(I-I*) +0.5y

If, for example, the target inflation rate was 2% and inflation (as measured by GDP deflator is 3%) then the Fed funds rate should be 2 + 3 + 0.5(3-2) = 5.5%.

In addition, if there is an output gap i.e. a difference between real GDP growth and "potential" GDP growth (a somewhat elusive concept) rates must be adjusted accordingly. If GDP growth exceeds "potential" then rates must be increased.

In practice there are several major considerations. The Fed reacts to the data slowly by adjusting the overnight rate slowly. The goal is the goal legislated for our monetary policy - stable prices and full employment.

Dr. Taylor has a web site at http://www.stanford.edu/~johntayl/

Dick Lepre

www.loanmine.com

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