Day After the Rate Cut, Lobbying Begins for the Next One

I will confess to being cynical about the reporting in the Wall Street Journal. As we have noted repeatedly in the past, it generally goes overboard to stress the positive its market-related reporting. That says the reporters too often lack the time or savvy to go beyond their sources’ spin.

Now Thursday was undeniably a bad day in the equity markets, and credit markets also exhibited “flight to quality” behavior. But while the New York Times attributed the reversal in part to fears about financial institutions triggered negative views about Citigroup and worries about other institutions, plus profit taking and “buy on rumor, sell on fact,” the Wall Street Journal embarked on a wide-ranging review of credit market woes. This normally would be useful, except the Journal’s first two sections are largely equity focused, despite the fact that the credit markets are worth more in aggregate. So the neglectful credit market coverage, with occasional bursts of catch-up like today, is probably confusing and may be alarming to mainstream readers.

And add to that the all too apparent subtext: the credit markets are fragile! The Fed funds rate is already calling for another rate cut in December!

Bernanke and the FOMC have no one but themselves to blame. Barry Ritholtz of The Big Picture called it:

This is brilliant:

“It’s like monetary policy is being affected by the tantrums of Wall Street As every parent knows, the worst thing you can do is give in to a tantrum, because then you get five more of them.”

-James Paulsen, chief investment officer at Wells Capital Management.

Looks like we are having a bit of a tantrum today . . .

In fairness, the Financial Times did tell us that things were pretty rocky:

Markets were so rattled that the New York Stock Exchange instituted trading curbs to prevent a wholesale sell-off. The Federal Reserve, which on Wednesday had hoped its 25 basis-point rate cut would ease financial conditions, injected $41bn in temporary reserves into the banking system – its biggest such move since September 2001. Meanwhile, the Vix index, a measure of equity market volatility known as Wall Street’s “fear guage”, rose 15 per cent.

But nevertheless, the Journal piece is disingenuous starting with its headline, “New Worries Grip Credit Markets.”

Huh? These are not new worries. They are more acute versions of existing worries. But per above, they may seem new to readers by virtue of the Journal’s intermittent coverage. And the Journal quickly, by the third paragraph, tells us that the markets don’t buy what the Fed is selling:

The angst in the financial markets stood in contrast to the views Federal Reserve officials expressed Wednesday. They said their latest rate cut, combined with a more aggressive one in September, should help forestall negative fallout from credit market turmoil on the broader economy.

Shortly thereafter, there is a section on how the housing market is getting worse. This is not news to anyone who has been following housing closely. The fundamentals are lousy and there is no reason to expect a bottom before 2008, and that could be optimistic:

The worry is that the huge financial edifice that is built on top of the now-shaky mortgage market could weaken, potentially causing lenders to tighten up on loans and slowing the economy. Besides the problems with banks and brokers, there was evidence of more problems in the mortgage market. Mortgage-servicing companies, which collect payments from borrowers, said delinquency and prepayment data were worse than expected.

“Mortgages are still deteriorating at an accelerating pace, and that’s scary,” said Karen Weaver, global head of securitization research at Deutsche Bank AG. “We haven’t come near a stabilization, and we expect things to get worse as the bulk of resets” of interest rates on adjustable-rate mortgages “have yet to come.”

The percentage of subprime mortgages — those to home buyers with weak credit — that were more than 60 days behind in their mortgage payments topped 20% in August, up from 18.7% in July and 17.1% in June, according to latest data from FirstAmerican Loan Performance.

Meantime, home prices in many markets have slipped. They were down more than 4% in the month of August from a year ago, as measured by the S&P/Case-Shiller index. The weaker prices have prevented some borrowers from refinancing into new loans loans, and have reduced the value of the collateral backing mortgage loans and securities.

However, some of the estimates from experts and the markets on current conditions and updated estimates of losses are solid reporting. But the discussion of collateralized debt obliagations is confused, as the writers try to apply data from subprimes (the unmentioned-by-name ABX indexes) to CDOs, which are completely different instruments. The Markit TABX index is what passes as a proxy for heterogeneous CDOs:

Mark Zandi, an economist at Moody’s, estimates that of the $2.45 trillion in especially risky mortgages currently outstanding — including subprime mortgages, interest-only mortgages, mortgages that exceed Fannie Mae lending limits and others — as much as a quarter could suffer defaults in the months ahead. Total losses on these mortgages, he estimates, could reach $225 billion. That would hit bondholders hard, since the value of mortgage securities is driven by the performance of underlying mortgages. And it could make such bonds harder to sell in the future.

Many expect the value of homes to continue to slip as well. Mr. Zandi puts the drop at 10%, from the market’s peak in the fourth quarter of 2005 to its projected bottom in the fourth quarter of 2008. That would be a decline that would wipe out more than $2 trillion in home values. That’s less than the $7 trillion in stock wealth wiped out by the tech bust, but still would represent a significant hit to the economy.

Because mortgages are bundled into securities sold to investors all over the world, the deterioration in mortgages’ value is having a widespread effect. Many of the more complex securities, known as collateralized debt obligations, or CDOs, are held by banks and brokerage firms. They’ve been the cause of much of the big losses at those institutions.

In CDOs, risk is portioned out to different groups of investors. Those willing to take the biggest risks buy securities with the highest potential returns, while investors who want more safety give up some return to get it. Already, the riskier “tranches” of CDOs have sunk dramatically in value. An index that tracks risky subprime bonds has fallen to a record low of 17.4 cents on the dollar, down 50% from August, according to Markit Group.

That decline, while worrisome, hit investors willing to take risk. But the recent turmoil stems from declines in the market for the safest securities. Rated triple-A, they should be affected by mortgage defaults only in extreme circumstances. An index that tracks triple-A securities is trading at 79 cents on the dollar, down from roughly 95 cents just a month ago.

At the top are “super senior tranches.” It is a decline in value of these supposedly safe securities that is hurting many banks and brokerage firms.

In October alone, ratings firms Moody’s InvestorsService, Fitch Ratings and Standard & Poor’s have downgraded or put on watch for downgrade more than $100 billion in CDOs and the mortgage securities they contain. In a glimpse of how much banks have at stake, Swiss-based UBS holds more than $20 billion of super-senior tranches of CDOs. They’re among the reasons UBS, which reported a third-quarter loss of 830 million Swiss francs ($712.8 million), has warned that its investment bank is likely to face further losses in the current quarter….

Thursday, odds of another rate cut shot up again in the wake of the stock market’s fall. Futures markets now perceive a December rate cut as slightly more likely than no change.

Print Friendly, PDF & Email


  1. jan perlwitz

    Yves, you quoted the Financial Times:

    “In fairness, the Financial Times did tell us that things were pretty rocky:

    Markets were so rattled that the New York Stock Exchange instituted trading curbs to prevent a wholesale sell-off. The Federal Reserve, which on Wednesday had hoped its 25 basis-point rate cut would ease financial conditions, injected $41bn in temporary reserves into the banking system – its biggest such move since September 2001. Meanwhile, the Vix index, a measure of equity market volatility known as Wall Street’s “fear guage”, rose 15 per cent.”

    It saddens me that even the FT doesn’t get it right with the $41 billion dollars. They should know better.

    Even though the Fed gave out new repos amounting to $41 billion dollars, $42.5 billion dollars of previous repos matured at the same day. The $41bn are basically just rollovers of previous repos. Actually, the Fed withdrew $1.5bn dollars from the system.

    Currently, every other Thursday the amount of new repos is higher than at other days, since repos of different duration mature together on those days, 14-days repos, 7-days repos, 1-day repos. On November 1, there were additional 2-days repos that were rolled over into 1-day repos. And every other Thursday the rollovers are falsely reported by the media as huge new money injections into the system done by the Fed.

  2. westwest888

    What if Ben Bernanke is using dollar devaluation in a game of chicken with China to force them to abandon the currency peg? Exhibit A:

    “The authority sold HK$7.828 billion ($1 billion) to defend the currency yesterday, twice as much as two previous interventions since Oct. 23.”

    I think the Fed knows everything we know, and then some but when they speak it’s to a world audience so they’re tight lipped. To us, it appears they’re trying to destroy the currency. I think they’re doing something analogous to seeing how far they can pull the cooling rods out of a nuclear reactor without reaching critical mass. Except the reactor is the global economy and the fuel is China.

    Congress, the cabinet, and the state department can’t seem to get China to let the Yuan (RMB) float. But maybe that rogue branch, the Federal Reserve, can force their hand. And can they restore the currency’s former value afterward without sending us into a huge recession?

  3. Lune

    Be careful what you wish for. Floating the renminbi probably won’t be the panacea U.S. politicians think it would be.

    Firstly, if China stops defending its peg, who’s going to buy the dollars we need to print every day to finance our capital account needs?

    Secondly, in the short/medium-term allowing the renminbi to appreciate would help U.S. manufacturers only if those manufacturers currently exist to take the place of Chinese manufacturers. Many of our manufacturing sectors aren’t just uncompetitive, they no longer exist. For example, if VCRs from China became more expensive due to renminbi appreciation, are there local factories that can produce VCRs? Or will we just swallow hard and pay the higher prices and keep importing?

    Of course in the long term, factories will be built and industries re-started. But for the next few years, for many products, we have no choice but to import even at higher prices.

Comments are closed.