Mortgage Market Week in Review

I’ve got to tell you, I’d love to be able to write one of my Friday updates and tell you about some good news or tell you, “You know, the week was very non-eventful and everything just flowed on quite smoothly.”      That certainly didn’t happen this week!    To attempt to bring/keep you up to speed on what’s going on in the mortgage market, I’m going to first attempt to tell you a bit about what has happened this week, then do a little question and answer session (I know, kind of scary when I answer my own questions!) and end up with some thoughts about what it means and how things look going from here.

So, what happened this week?   Well, frankly, the financial systems of the world almost had a total meltdown.   Let me explain.   There’s essentially two “main parts” to the financial markets.   There’s the equity side (the stock markets) and the debt side (bonds, loans, mortgages, Fed Funds, and all other types of borrowings).   The equity portion of the markets got hammered, but it wasn’t, with the exception of a few firms, a total meltdown.    On the debt side, it really was very close to a nuclear reactor meltdown.   I could go on and on with details of how the Fed Funds rate (supposed to be 2.0%) jumped to 6.0%.   I could tell you how some treasury bonds were selling for less than what they were worth (meaning someone who bought them was guaranteed to lose money.   I could tell you how there were auctions for certain financial instruments and no one showed up (AT ANY PRICE.)   I could tell you the details about how AIG got basically an $85,000,000,000 margin call and the only way they could avoid defaulting on it and bringing down the entire financial markets was by giving 80% of the firm to the government and paying over 12% interest on the money. AIG is basically paying credit card rates!   Let’s put it this way, I’ve had people ask me, “Was it really that bad out there?”   Short answer, yes, it really was that bad.

Here’s the high/low points of what happened this week (starting with Monday).   I’m going to be brief because it’s all been on the news (and I’ve written about a lot of it already).

1. Lehman filed for bankruptcy. Just to put it in a little perspective, I believe that Abraham Lincoln was president when Lehman Brothers was founded.

2. Merrill signed an “agreement” to be bought out by Bank of America, believing that it’s not going to be able to remain standing without additional help.   Later in the week, it turns out that Bank of America had cut Merrill’s credit lines last week because they were afraid that Merrill was going to follow Bear Stearns and Lehman and go under.

3. AIG got downgraded by the rating agencies and that means they have to come up with additional cash.   Buddy, can you spare $85,000,000,000?   Oh, and I need it by tomorrow or the “gig” is up.

4.Late yesterday and then more this morning, due to the incredibly increasing strain on the credit markets and the fact that banks weren’t willing to loan each other money, the government announced that they were going to make a preemptive broad attempt to restore calm and confidence to the markets.   Oh, and it was going to cost “Hundreds of Billions” for the tax payers.    Read Paulson’s speech here if you’d like.

Now some questions and answers:

Question – what is the government going to do?

Answer – they are essentially setting up a company and using that company to buy loans from banks who are having trouble because of those bad loans.    Let’s say that Washington Mutual has $25 billion worth of bad loans on their books (I don’t know, I’m just plugging in a number).    They are in financial trouble because they can’t sell those loans.    The government will buy them At A Substantial Discount, hang on to them until the markets turn around and then attempt to sell them and get their/our money back at that point.

Question – why are they doing that?

Answer – because very simply, the markets were in such bad shape and getting worse that the alternative would have been financial disaster.

Question – why is the stock market going up so much today?

Answer – relief that the financial world isn’t coming to an end.

Question – What else are they doing?

Answer – it’s not a “done deal” until it gets approved by Congress, but this appears to be the main thing that they are doing.   There are other relatively minor adjustments they are making in attempting to manipulate the markets into calming down.

Now some thoughts about what it all means:

1. For the mortgage and housing market – it means that the mortgage market won’t freeze up.   I’ve often said in the last year, as long as Fannie and Freddie keep buying loans, we’ll be okay.    This move makes it pretty much guaranteed that the housing market and the mortgage market won’t freeze up.  That is a very good thing because if the housing market took another hit, we’d be in even deeper straits……    At the same time, it’s not the be all and end all of the housing market.   We’re still dealing with too much inventory, rising foreclosures, falling prices and tightening credit requirements.

2. For the banking industry – it means that the banking and financial markets have dodged a bullet.   Does it mean that instantly all banks are healthy?   Does it mean that we won’t have any more bank failures?   No, it doesn’t mean either of those.    The four words in bold up above, AT A SUBSTANTIAL DISCOUNT, could make it very interesting.   If a bank sells a lot of loans to this government organization, it is going to have an impact on their balance sheet and their capital ratios and that is an area that we don’t know enough details about what that would mean.   I still believe that we will see some substantial consolidations in the banking and investment world as this continues to unfold

For the economy as a whole – I think that it’s going to keep things from slipping a lot farther down, but there are a lot of issues that our economy is facing that we’ll still be facing.

The issue of Unintended Consequences – I’m a believer in the theory of unintended consequences. There are many people who lay out a pretty convincing case that when the Fed slashed interest rates after 9/11, they left them low too long and that ignited the greed and chasing of profits that led to the excess of the housing bubble that has caused all of the problems we have now.   I’m concerned that the massive government takeover (which is essentially what it is) of the financial system, while it’s necessary right now, could potentially and will probably have some long term ramifications that we really don’t have a clue on and they probably won’t be very healthy.    Only time will tell, but I believe that what happened this week raises the stakes in this year’s presidential election even higher than they already were.    The next administration is going to have some pretty substantial issues and questions to deal with in regards to the financial markets and I hope they do what’s best.

So how do things look from here for the housing and mortgage market?  A couple of observations:

1. Due to the massive amounts of money that the government is going to have to borrow to fund all of this intervention, I don’t see mortgage rates dropping lower.   I expect that we’ll see “relatively stable” rates in the near future but 6 to 12 months from now, I anticipate that it’s going to be more expensive to borrow money than it is now.

2. I believe that we are going to continue to see credit requirements tightening for not only mortgages but virtually all types of credit.   I think one lesson that was learned from this week is that “we” (collectively) made credit way to easy to get and it came back and bit us in a BIG way.

3. While I think this action by the government stabilized the credit markets, I don’t believe it put a bottom in the housing market.    The only way that they could do that is for them to…… (I’m not even going to go there!)   I think we need to continue to work through and eventually burn off the excess inventory until we reach a bottom and then things will start building back up.

So here’s hoping that next week is a lot quieter of a week than the last few have been, but I’m not sure it’s going to be.   But know this, the sun will come up tomorrow, people will still be buying houses, the banks will still open, Armageddon didn’t wipe us out and for that, I’m grateful.

Until next time…..

Tom Vanderwell