The Fed, Treasuries, and Mortgage Rates

It was an interesting day in the markets even though gains were modest. Tonight I want to discuss treasuries, mortgage rates, and the Fed's dilemma. I know this sounds really exciting!(not) However, I think you will find it helpful in terms of understanding whats going on in the markets right now.

There is a ton of maneuvering going on behind the scenes as the Fed tries to prevent this debt bubble from bursting. The easy first response from the Fed when this crisis first hit was to slash rates, and provide a ton of liquidity to the financial system. The Fed hoped that this would stimulate lending and borrowing and keep the economy going.

So how did that work?

As we all know, the results are not impressive. So what have been the repercussions of the Fed cuts?

In a nutshell: Higher food inflation, a weaker dollar, $130 oil, and mortgage rates that are basically within a 1/4 point from where they were when the rate cutting began. Pretty impressive isn't it? Ha Yea right.

The Fed decided to switch gears after this experiment failed and started providing liquidity by other means. Examples of this are the discount window where the financial institutions including investment banks could use AAA bonds as collateral to borrow cash at a discounted rate.

They also started up Lending Facilities that allowed the banks to use other forms of AAA debt like student loans for collateral to borrow additional money.

So where are we now?

Well throwing all of this liquidity into the system has its reprocussions. We have created a whole set of problems that has really put the Fed in a bad spot. With liquidity comes inflation. This is problem number one.

Problem #2: You can't throw all of this liquidity at the financial system without paying for it. The Fed does this through holding auctions and selling things like 2 and 5 year treasury bonds. There is a $60 billion dollar sale that began today.

So how are the auctions going?

From the looks of Bloomberg today demand looks to be slow. The central banks of the world are growing tired of buying these Treasuries that continues to get devalued by inflation and our weak dollar.

As a result, the yields must rise in order to make them attractive to investors. Here are some highlights from Bloomberg:

May 28 (Bloomberg) -- Treasuries fell, pushing the 10-year note's yield above 4 percent for the first time since January, as a measure of durable-goods orders unexpectedly rose and the government's two-year note sale was met with tepid demand.

Bonds extended their losses after the auction of $30 billion of the securities drew a higher yield than bond-trading firms forecast and attracted the lowest level of demand since February from a group that includes central banks. The government will sell $19 billion of five-year notes tomorrow.

The yield on the current two-year note rose 12 basis points, or 0.12 percentage point, to 2.62 percent at 4 p.m. in New York, according to BGCantor Market Data. It was the highest level since Jan. 11. The price of the 2.125 percent security due in April 2010 fell 7/32, or $2.19 per $1,000 face amount, to 99 2/32.

The benchmark 10-year note's yield increased 11 basis points to 4.03 percent. It's the highest level since Jan. 2. The security's rate is 1.40 percentage points higher than that on two-year notes, compared with 1.54 percentage points when the government held the last two-year note auction on April 23.

In the government's sale of two-year notes, indirect bidders, the category of investors that includes foreign central banks, bought 22.4 percent of the auction. In the past six sales, the group bought 24.9 percent on average.

Fed Rate Outlook

Futures on the Chicago Board of Trade indicated a 73 percent chance the central bank would increase its target rate for overnight lending between banks by at least a quarter- percentage point in December, compared with 55 percent odds a week ago."


Final Take: The Fed's Dilemma

The fact that the 10 year has risen to over 4% is a huge red flag! This is not good because its going to push mortgage rates higher. The reason the 10 year is moving higher is because the Treasury is handing out money like candy, and they need to raise cash in order to continue to do this.

The massive spending of cash by the Treasury comes at a price. The bond market then pushes the 10 year yields higher as a way to protect itself. We are at a 7 month high on the 10 year rate according to CNBC. It closed at around 4.00%.

This is BAD BAD BAD for housing because the 10 year bond rate is used to set many different mortgage rates. If the Fed continues to spend like a drunken sailor, then it risks spiking rates severely in the bond market.

This could DESTROY the housing market with higher mortgage rates. People can't afford to buy these homes at the current rates. Push rates to 8-9% and you will see a housing crash with virtually zero activity.

So what alternative does the Fed have?

The alternative is to start pulling liquidity from the system. They know that the financial system is in jeopardy if the 10 year rate continues to rise because housing will come to a come to a standstill. The banks are teetering on insolvency as it is and the Fed realizes a housing crash could be the final nail in the coffin.

So how does the Fed pull liquidity from the system?

The Fed can start pulling liquidity from the system by not touching interest rates or increasing them slightly and let equities take a tumble. They could even try to force a sell off. The reason they would do this is if equities drop, people will fly into treasuries out of fear which will then keep the treasury bond rates low due to high demand. This would then allow for the cheap lending to continue.

They could also pull liquidity out by changing what they accept at the discount window. I don't see this as a viable alternative because it would put too much pressure on the banks.

The one thing they know for sure is they cannot afford to let borrowing rates rise. The 10 year must not rise much above 4%. If the Fed has to stop spending spending and sacrifice the stock market in order to do it then that's the cost of doing business.

The risk of popping the debt bubble through higher borrowing rates is a bigger risk to them versus saving the financials through bailouts in the equity markets. The spending must stop now or we face a severe inflationary crisis with soaring interest rates.

The days of the Fed being a backstop to financials like Bear Stearns are over. They have spent $700 billion dollars and its forcing rates up in the bond market.

So the Fed faces a tough choice. Do you keep the liquidity flowing and risk inflation along with soaring interest rates to save equities, or do you pull liquidity out in order to keep borrowing rates low and protect the dollar and the debt bubble at the expense of the stock market?

Tough choice isn't it?

Subprime Investors Fight Back: Here come the Lawsuits!

Well we had an interesting development overnight ladies and gentleman. It appears that the investors who bought certain types of subprime AAA rated securities want their money back!

The Wall St. Journal reported this bomb today ,and the effect of this development is far reaching and very bad news for the lenders. Folks, the lawsuits from this housing bust are going to go on for years.

Here are the highlights from the article. First, take a look at the Countrywide graph from the article showing the rapid rise in bad loans that Countrywide has been forced to eat because the lending standards were so bad.

Some highlights from the WSJ:

"Already burned by bad mortgages on their books, lenders now are feeling rising heat from loans they sold to investors.

Unhappy buyers of subprime mortgages, home-equity loans and other real-estate loans are trying to force banks and mortgage companies to repurchase a growing pile of troubled loans. The pressure is the result of provisions in many loan sales that require lenders to take back loans that default unusually fast or contained mistakes or fraud.

Countrywide Financial Corp., the largest mortgage lender in the U.S., said in a securities filing this month that its estimated liability for such claims climbed to $935 million as of March 31 from $365 million a year earlier. Countrywide also took a first-quarter charge of $133 million for claims that already have been paid.

The fight over mortgages that lenders thought they had largely offloaded is another reminder of the deterioration of lending standards that helped contribute to the worst housing bust in decades.

Such disputes began to emerge publicly in 2006 as large numbers of subprime mortgages began going bad shortly after origination.

Repurchase demands are coming from a wide variety of loan buyers. In a recent conference call with analysts, Fannie Mae said it is reviewing every loan that defaults -- and seeking to force lenders to buy back loans that failed to meet promised quality standards. Freddie Mac also has seen an increase in such claims, a spokeswoman says, adding that most are resolved easily.

Additional pressure is coming from bond insurers such as Ambac Financial Group Inc. and MBIA Inc., which guaranteed investment-grade securities backed by pools of home-equity loans and lines of credit. In January, Armonk, N.Y.-based MBIA began working with forensic experts to scrutinize pools it insured that contained home-equity loans and credit lines to borrowers with good credit. "There are a significant number of loans that should not have been in these pools to begin with," says Mitch Sonkin, MBIA's head of insured portfolio management.

In a lawsuit filed in December in Superior Court in Los Angeles, units of PMI Group Inc. alleged that WMC Mortgage Corp. breached the "representations and warranties" it made for a pool of subprime loans that were insured by PMI in 2007. Within eight months, the delinquency rate for the pool of loans had climbed to 30%, according to the suit. The suit also alleges that detailed scrutiny of 120 loans that PMI asked WMC to repurchase found evidence of "fraud, errors [and] misrepresentations."

PMI wants WMC, which was General Electric Co.'s subprime-mortgage unit, to buy back the loans or pay damages. Both companies declined to comment on the pending suit."

Final Take:

We are in the beginning stages of seeing the fallout from this housing bust, and the buyers of the AAA subprime crap sandwiches want blood. As you can see above, the investors are now going through these securities loan by loan looking for anything such as: Fraud, loans that didn't belong in a certian securitization due to risk, and an overall lack of quality standards.

Notice the one pool of loans with WMC had a 30% default rate within 8 months! This is called lending to anyone with a pulse!!!

Of course now the monolines like MBIA and Ambac believe they may have now found an "out", and are climbing over each other to jump aboard this legal train.

The monolines see this as an opportunity to get out of many of the contracts that they made with the lenders to insure this AAA crappola. The liability of insuring these securities has threatened their AAA ratings as well as their survival.

PMI is suing for the same reasons. To get out from the liability.

Expect every investor that got stuck with these AAA subprime mortgage pools to look over every loan with a fine tooth comb looking for away to get paid back. They realize that at the peak of the market, the lenders made many bad loans that should have never been done, and then stuck them into AAA securities where they never belonged.

Countrywide already has $1 billion in estimated liability on loans that are so bad, they will be forced to take them back from the investors that they sold them too and eat them. Imagine how many more are on the way?

Notice how the court battles are also spreading into home equity loans and other real estate loans. Its only going to get worse. Many subprime loans haven't even reset yet!

The amount of greed and fraud that resulted in this housing bust runs far and wide, and the courts will be tied up with this for years trying work this all out.

Anyone that still thinks Bank of America wants any part of Countrywide needs to get their head examined!

Countrywide will end up being the poster child for all that was wrong in the housing market the past 10 years.

$12 a Gallon Gas Possible? Dr. Hirsch Thinks So

Since oil is the focus of the market right now, I thought everyone would like to get some more insight on oil from the experts. I was surprised to see such a bearish piece like this on CNBC. This is from May 20th so its pretty current information.

Maybe we should be enjoying the $4 a gallon gas we have right now. It looks like gas could go much higher. We better find an alternative source of energy fast or we are in for a rude awakening!