One perversely pleasant sign in this deepening credit panic: on Friday, frightened investors began to buy top-quality mortgages as fast as Treasurys, and the lowest-fee 30-year loans fell toward 6.5 percent.
In the prior two weeks, the failure of mortgage yields to follow Treasurys was worrisome for three reasons: it looked as though all mortgages had become toxic; second, a hallmark of a really bad credit crunch is a lock-up extending to AAA paper (which Fannies and Freddies certainly are); and lower fixed rates are crucial to offset the very rapid re-pricing and/or outright removal of Alt-A and subprime credit.
In the big load of July economic data last week, the important stuff arrived softer than forecast: payrolls, unemployment, autos, the twin surveys by the purchasing managers’ association, and factory orders. Softer, but within the range of the last year, and of themselves no reason for the Fed to contemplate a rate ease.
However, by the end of an ugly week, as credit distress extended far beyond mortgages, voices rose — led by Howlin’ Jim Cramer — to demand intervention by the Fed.
After S&P announced Thursday that it would downgrade Bear Stearns’ credit, Bear CFO Sam Molinaro said, “In my 22 years in the industry, this is as bad as I’ve seen the fixed-income market.”
Hah. Another kid who thinks he’s been around for a while. Nobody can predict how this crunch will play out, but a brief history of prior ones can help to bracket the outcome.
Start six years ago, when the combination of 9/11, the technology business collapse and threat of deflation might have caused a credit panic, but the Fed flooded the system with 1 percent money and there was no way for a crunch to get going.
1997 brought a systemic threat, the “Asian Contagion,” which culminated in the Russian default in August ’98 and failure of hedge fund Long Term Capital Management, a potential crunch snuffed by the New York Fed in a single meeting. International aspects threatened the global economy, but the Fed cut its rate three times, from 5.5 percent to 4.75 percent to be sure that the American engine pulled the globe through. However, the LTCM collapse was a single-firm affair — big, but nothing like this diffuse situation in ’07. Diffusion may mean safety in distributed risk, or viral contagion.
In ’91 we had a little, dish-shaped recession precipitated by a credit crunch whose origins are still debatable, but probably an end-stage consequence of the Savings & Loan meltdown. The Fed was slow to recognize and ease (cost Daddy Bush his job), but a rate cut to 3 percent headed off any big trouble.
In 1987 Fed Chairman Alan Greenspan had hardly warmed The Chair, in office only two months before the stock market oops-a-daisy. He wasn’t even in the country on the day of the crash, and the very able vice chair (Roger Ferguson, recommended by Greenspan to succeed him over the current occupant) handled the whole thing easily. This was a classic “lender of last resort” operation, the Fed quickly informing all the big banks and dealers that the Fed would cover all bets, and sort it out later. Panic never had a chance to spread from stocks, and within six months the Fed was back to raising its rate, squeezing the ’70s inflation.
That’s the limit of young Molinaro’s experience, and at that, more experience than most on Wall Street. Too bad.
This episode is nothing — nothing — compared to October ’79, when over one long weekend then-Fed Chairman Paul Volcker announced that the cost of money would float free with demand. Many mortgage bankers never answered their phones again. Mortgage rates went from 10 percent to 11.5 percent over that weekend, and to 13 percent by Christmas. The technical top was 18.1 percent in 1981, but that was statistical artifact: lights-on-but-dead S&Ls priced money just beyond demand. There wasn’t any mortgage money, except the first of the new-fangled adjustables, start rate a-hell-of-a-deal 16 percent.
THAT was a credit crunch. Did the Fed back off to protect housing or the economy? A bitter, “Hah!” to that. The Fed knew that the entire S&L industry would fail, its 9 percent-paying portfolios under water to 14 percent deposit cost, and let it go for greater good. Unemployment over 10 percent, a two-stage recession lasting three years … but inflation had to be beaten or everything would be lost.
Farther back, ’73-’74 was the first oil-shock inflation, just as deep as the ’79-’82 double-dip, but short, much like the ones in the ’60s and ’50s.
So, today you want the Fed to do something to bail out housing, or The Street, or just the stock market, maybe? Remembering that any action would be condemned (perhaps accurately) as interference with a normal and cleansing correction, removal of moral hazard, and restoration of the much-derided Greenspan Put? Prematurely ease and waste the whole inflation-fighting benefit of the tightening cycle?
The Fed could cut its rate from 5.25 percent, in anticipation that sudden shrinkage of mortgage credit will push housing into a heap, and finally bury the economy, too. But that’s hard to justify on two grounds: there’s nothing “high” about today’s 6.5 percent mortgage money: when the Fed cut in ’91, mortgages were 10 percent; in ’98, 8 percent. Anyway, the Fed is supposed to wait to ease until the last possible instant to get the most inflation-fighting impact from the tightening cycle.
Instead the Fed could now offer, ’87-style, to cover all bets, but there’s not yet an indication of systemic dominoes. Not even Bear has as much credit trouble as prospect of losing litigation. The Fed can’t stop the cruelest part of this mortgage/housing meltdown, the punishment of unwary home buyers, nor should it stop the equitable aspect: not a single failed mortgage firm or investment venture has suffered more damage than deserved. Same for the demise of the easy leveraged buy-out.
For the moment the Fed shouldn’t do a thing other than to watch the real economy and be alert to the possibility of systemic credit failure, which leads to two ponderables: one short term, one long.
If this crunch gets uglier, will the Fed know how to respond? A credit crunch is a pure market event having little to do with monetary policy. From 1987 to 2006, Greenspan deployed his extraordinary market sense in these decisions, over time with such demonstrable skill that policy became a solitary matter. Does the Fed still possess the institutional skill to guide current Fed Chair Ben Bernanke, a monetary academician, in the markets? Or did that talent atrophy during Greenspan’s time?
In the longer run, free-marketeer that I am, it is a mistake to allow Wild West conditions to continue in the mortgage market. Eleven trillion in outstanding home mortgages upon which housing and the economy depend cannot continue to be the playground of unregulated Wall Street derivatizers. It will be a while before the survivors of this episode get quite so carried away again, but not long enough.
Lou Barnes is a mortgage broker and nationally syndicated columnist based in Boulder, Colo. He can be reached at lbarnes@boulderwest.com.
