Raise rates and give them a shock, or stop doing coupon passes. Drop the money supply- that would scare the daylights out of the perpetually easy bond market.
Wouldn't that just shock the stock market into a potential crash situation1 Darned if they do, bedeviled if they don't.
I think we are rapidly approaching a managed decline in the dollar of 15 to 20 percent, with 5 percent now behind us.
All those years of putting up with tedious Fedspeak tea-leaf reading, and now, in our golden years, we will have to deal with txt msgs from Mr. Market's Blackberry instead.
Wall Street Players are betting BIG TIME that, whether they own BB or the FED's been rendered as toothless as its Nonconforming Mtg. Guidance, Ben Bernanke is no threat to Wall Street.
When PIMCO's Bill Gross questions what's driving 10 year yields, alarm bells should be resonating LOUDLY somewhere within the FED. Yet, the remains silent and markets advance, oblivious to signals that have shaken past markets. Why is the FED silent about what's really driving ten year yields? Better yet, what's the purpose of the FED since AG personally saw to the total dismantling of Glass-Steagall? Is it to process checks & front run for Wall Street?
BB looks MORE ineffective and more disappointing with each passing day. When will Krugman, DeLong & the rest of our opining, reality-based, Republican-bashing Economists take him to task?
Here's the first question I'd ask him: Total repeal of Glass-Steagall monumentally and forever changed the way our financial sector conducts business. Why hasn't BB's FED recommended to Congress to bring regulatory control of our financial sector into the 21st Century to meet the new challenges before us? PIMCO - Investment Outlook- December 2006 "Reality Check"
CR, do you think that some of the Fed's "hawkish rhetoric" on inflation might be actually due to the possibility of a falling dollar and not what they are seeing in their data on the economy? Most articles I see seem to be focusing on how the how the Fed is not reading the economy right so the market is discounting their warnings, knowing that they will have to drop the rates to stimulate the economy. Would it be possible that the Fed is reading a probable drop in the value of the dollar (along with other such issues like the housing bubble) as inflationary forces and are trying to support the dollar or at least moderate any sudden movements?
What got me thinking along these lines was the paper by Paul Krugman that cites his infamous "Wiley E. Coyote" theory on the lack of support for and possible drop of the U.S. dollar. And recently, Fortune noted that a falling U.S. dollar would put the Fed between a rock and hard place, having to choose between stagflation or stimulating the economy and having a plunging dollar.
CR - an amateur question about fund rate probabilities if you'd be so kind ? How exactly do futures rates tell us what the expectations are ? Tried to sort thru the Cleveland web site and decoding that and the typical finance news escapes me.
Short term consumer debt 2.4 trillion
mortgage debt 10.4 trillion:
seems the consumer is locked into heavy debt on a long term basis, thanks to refi and home ATM. So just what would a lower overnight leanding rate do for consumer spending?
Ron, you're forgetting about the ARMs. Anything that resets at 12 or 6 month intervals "reprices" off the short end of the curve, not the long end. Also, when the cost of funds goes down, banks are irresistably attracted to the mortgage carry trade (in ARMs, that is). That could, I think, be enough to cause a cash-out refi boomlet, ceteris paribus--I am regularly told that there's enough equity out there for enough homeowners to support another one.
Andrew, thanks for the reminder about Krugman's excellent paper.
I think the Fed's hawkish comments are because they're truly more worried about inflation more an economic slowdown. That is also the consensus view of most on Wall Street.
As Krugman noted, if the dollar drops, the Fed's hands might be tied, not by the weakness in the dollar, but by any related inflation (imported goods cost more).
There are some very complicated interactions - if the U.S. slides into recession and drags the world along for the ride - China might sell U.S. securities to keep buying oil and hard goods to keep their economy out of recession. That might push U.S. rates higher - and complicate the Fed's job. I need to think about this some more - and reread Krugman's paper!
DaveL, I haven't worked through the math - I've just been taking the probabilities from the Cleveland Fed. So I don't think I can explain HOW they calculate the probabilities. Here is the paper that describes the methodology: Recovering Market Expectations of FOMC Rate Changes with Options on Federal Funds Futures. That should help with any insomnia!
Ron, it's an easy mistake to make. Just remember that the 1 in 3/1, 5/1, 7/1, etc. refers to the frequency of ajdustment after the initial adjustment (which occurs after 3, 5, or 7 years). Because the loan adjusts every year, it has the duration of a one-year maturity. It is therefore indexed to something with a 12-month maturity such as a 1 year treasury (or a Constant Maturity Treasury, CMT, of 1 year) or a 1 year LIBOR. Actually, almost all subprime ARMs and a fair number of "Alt-A" ARMs have 6-month adjustments (2/6-month is very common), and are usually indexed to the 6-month LIBOR, although wackier 6-month indices exist. The Option ARMs are most frequently indexed to the Monthly Treasury Average, MTA, because they adjust every month (after any initial fixed period that might be offered), giving new meaning to the phrase "short end of the stick."
The initial interest rate of any ARM will, of course, be set with reference to the appropriately longer-maturity bond, option-adjusted and bond-equivalent effective margin applied, boatloads of discount points paid by desperate builders buying it down, etc.
On the housing bubble, as it relates to the median purchase price:
This is looked to by the "housing optomists" to prove a leveling, flattening market.
But correct me if I'm wrong, this is only telling us how much people are willing to "borrow" to buy a house. It says nothing of the house value itself. Thus it's more a measure of affordiblity and the price of money...not the price of individual houses.
The old saying goes, you can buy the house, or you can buy the money to buy the house. Since the price of money is flat or dropping, I'm surprised we're seeing the drop in median prices we are. It is no where near the actual drop in prices for individual houses.
Unlike stocks, where the markets daily measure the relative cost of individual assets (stocks), the housing optomists point to what was spent or invested, not what was purchased. It would be equivilant to looking at the $ amount individual investors used to purchase stock and not how much or how little that money bought. How would you know if the stock prices were dropping or rising if you could only see the amount invested. Seeing Joe Investor bought a million dollars worth of stock last month, and this month Jane Investor bought anther a $million worth of stock...ie the market is flat?
My guess is that buyers first figure out how much they can afford and then go out to find the most house for the money. When the formally $500,000 house comes into the affordability $400,000 price range of a prospective homebuyer, he makes the purchase because it's a deal. No matter what, he was gonna spend $400,000 if he bought because that is what he can "afford" He just gets more for his money.
Now, does this not make perfect sense?
People look at the supply and demand and wonder how prices can stay so high. It seems understandable that those who do decide to buy do so with today's lending standards and "get as much as they can afford". i.e. flat purchase prices. Yet look around, prices on individual houses...if they even get bought.....are dropping buy huge percentages.
This matters to the individual home owner. But does it matter to anyone else?
Does anyone see that the bubble is not the price of homes but simply the amount people are willing to borrow to purchase an asset, no matter what form that asset takes.
And the bubble pops not when the asset is upside, but when the buyer cannot service the debt. Cars are bought and turn upside everyday. There is only a problem when you can't pay the car loan and can't sell the car. If the car loan is no problem, then the asset price is no problem.
Housing prices seem irrelevant when compared to ability to service the level of debt. If current debt levels are unserviceable, then a flattening median price of homes means more trouble for the economy, not less.
Those who decide to buy are going to buy as much as they afford....and since the price of money remains stable, the amount spent on homes remains stable.
Now YOUR home may have to be sold to someone planning on only spending $400,000 since that buyer willing to pay $500,000 can now afford the home that was $600,000 down the street.
Falling home prices, yet stable median home price sold. Apples and Oranges.
No you are no idiot, but don't confuse the micro-logic of doing something with the macro-effects... they don't always behave in parallel... the might run off in different directions.
The institutions who lend that money (set the 'price' for that money) are deeply concerned about the value of those assets because they own thousands of those loans collateralized to them and a few always fail... so for them the fall back is in the valuations... if there is value there they can at least recover something.
Secondly the higher the valuations relative to the amount borrowed, the less likely the loans actually fail - the troubled owner has options if the LTV is quite a bit lower than 1.0, far fewer the as the LTV approaches 1.0 and none above 1.0 (think of it as 'one point oh-oh'.
So they DO care about the valuations and not just that a particular borrower is paying on time.
This concern will, in a healthy market, result in higher prices for credit and act as a feed back restraining the riskiest practices... you know the moral hazard thing.
I think the trillion dollar question is... "Is this a healthy market or is the market sick?"
I think we are all trying to get our head around that last question. AJ - you are more than welcome to add your thoughts & contribute to our group therapy sessions anytime.
Avg Joe, I've been thinking the same thing lately. That the median price number bandied about by pundits is not telling the whole picture of this market. I fully agree with your observation and subsequent analysis of this metric. Well put.
Tanta: couple quick questions.
Basically if the FED does cut overnight leading rates it only affects those ARM's not connected to a LIBOR. 2nd it seems the rate cut needs to be significant in order to help those facing resets?
ron -- the libor rate trades at a spread to treasuries about 25-50bp at the short end. The fed funds rate is actually closer to libor than overnight treasury because banks have worse credit than the govt.
Sharkbait brings up the other half of the issue, which is margin. Prime quality treasury-indexed ARMs generally have a margin of 2.75, so reset rate = index value + 2.75 (rounded to nearest .125, subject to per-adjustment caps). 2.75 is, then, the approximation of how much worse a credit risk an individual (secured) borrower is than the government. Prime quality LIBOR-indexed ARMs generally have a margin of 2.50, because this is the risk premium of an individual (secured) borrower over a bank. In theory, then, the Treasury-LIBOR spread is "captured" in the margin structure, so the final rate to the borrower on either loan is comparable.
The depth of the rate cut needed to make a difference depends, of course, on where you started (and what effect the rate cut has on the slope of the yield curve, which is where historical expectations battle "condundrums"). As with the significance of delinquency rates, its a matter of the vintage youre talking about. If you took a LIBOR-indexed 3/1 ARM in 2003, which a whole lot of folks did, your discounted start rate could easily have been 3.00%. If memory serves me correctly, 1Y LIBOR hit 5.00 around 36 months after the bulk of these loans originated, and they generally had 2.00% per-adjustment caps, so 5.00 index + 2.50 margin = 7.50, adjusted down to 5.00% by the caps for the final rate. (Most of the 5/1s and all of the 7/1s have 5.00% first adjustment caps, not 2.00%). A loan does not become "fully indexed" until its rate = index plus margin, without the effect of caps limiting the final number. Caps are, basically, the price the investor pays for mitigating credit risk (caps limit the damage of "payment shock" to the borrower).
Yield curve inversions are a bummer if they happen when your ARM happens to adjust. This is, of course, not "normal," but we certainly made and took ARMs as if it could never happen. Also, the "historical" performance of ARMs in terms of credit quality, prepayment speed, and post-adjustment yield approximation to "market" was based on the "historical" fact that people took ARMs when long rates were very high, in order to 1) get the initial discount or spread between initial ARM rates and the long fixed rate and 2) follow the market down without having to pay the cost of refinance. In 1985, when I got a 1/1 ARM with a start rate of 10.50%, that was a smart move. The whole equation gets hinky, though, when you have this phenomenon of record ARM origination during record rate lows (any rate, long or short). So put 1) discounted initial rate together with 2) origination at the bottom of the rate cycle and 3) inversion of yield curve at time of adjustment and you get the fact that a bunch of ARMs reset up as far as the caps allow at the same time that long rates were not a whole lot different than they were when the loan was originated. Insofar as borrowers took that 3.00% start rate back in 2003 because it was a great deal, they're either going to accept their current 5.00% philosophically or refinance into a fixed at around 6.00%. Insofar as they took the 3.00% because they barely qualified even with an interest-only payment, and they didn't get 10% raises in each of the last three years and their property taxes didn't stay at pre-boom levels, there's a bit of problem with refinancing into fixed, as there is affording staying ARM.
How deep does the rate cut have to go to bail them out? For some borrowers at the margin, it has to be deep enough to basically erase the risk premium, and "not gonna happen" sounds reasonable to me. If Fed easing causes a refi "boomlet," it is likely to be among those marginal ARM borrowers refinancing into another ARM, assuming that if they needed "nontraditional guidelines" to qualify first go-round those guidelines will still be there this time and that there's sufficient equity to allow them to roll financing costs into the loan and still be under 95% LTV or thereabouts. What I'm assuming here, with limited confidence, is that most people who want/qualify for a fixed rate already have one (refi booms do that) that will look like a good deal if Fed eases and long rates rise. That said, though, it's hard to predict how desperate people will be for cash-out; if we see low-rate fixed borrowers refinancing into ARMs for cash, we just have another consumer bailout that will need another consumer bailout (home prices or rates) in 3 years or so, absent certain fundamentals that rhyme with rising income.
And Ron is of course right to question how direct or uncomplicated the relationship is between cost of funds and short/long bond prices and hence mortgage interest rates. Duration/prepayment speed enters the picture; prime mortgages generally give the borrower a free put but Alt-A and subprime loans increasingly carry a prepayment penalty; rising long rates coupled with stagnating or declining existing home sales will extend the expected average life of mortgage loans generally and ARMs specifically from recent trends; all this coupled with upward pressure on risk premiums in light of current MBS performance will certainly complicate the impact of Fed easing, if and when it arrives, on mortgage rates.
And with that, I have finished both my store of wisdom and my first pot of coffee.
CR - thanks, I think . Insomnia definitely won't be a problem.Expectations calculas of Black-Scholes options pricing leading to multi-dimentional OLS estimates is not quite my idea of bedtime reading. But it would save on the Scotch toddies for sure.
More seriously the Fed may be between the devil and the deep sea because pressures on the $ would indicate a need to keep, or even raise rates. It'll be a matter of priorities and keeping offshore funds flowing given tat we're sneaking up to the edge of a cliff is more important than avoiding a 'mild' recession. That's actually true in a macro sense when you work out the consequences of each path.
Jim Jubak's column on MSN Money Central has a wonderfully straighforwad discussion with no B-S calculas thrown in.
Raise rates and give them a shock, or stop doing coupon passes. Drop the money supply- that would scare the daylights out of the perpetually easy bond market.
Wouldn't that just shock the stock market into a potential crash situation1 Darned if they do, bedeviled if they don't.
I think we are rapidly approaching a managed decline in the dollar of 15 to 20 percent, with 5 percent now behind us.
Share and enjoy!
I think the probability of a rate hike in march might really jump on Dec 8. Unemployment report comes out. Watch out for 4.6%-4.7%.
CR, you are wrong. Look at the jump in probability of 5.5%
"Federal Reserve officials are getting a first-hand lesson in the law of diminishing returns"
If they even dared to think about cutting rates, they will discover this law also applies to liquidity too.
charts, I've been wondering about Friday too. My guess is the unemployment rate will rise - the market expects 4.5%.
EZrider, when the Fed eventually cuts rates, I also think they might be in for a surprise.
Best to all.
All those years of putting up with tedious Fedspeak tea-leaf reading, and now, in our golden years, we will have to deal with txt msgs from Mr. Market's Blackberry instead.
OMG 2 old 4 that LOL /rally
What about the declining dollar?
Wall Street Players are betting BIG TIME that, whether they own BB or the FED's been rendered as toothless as its Nonconforming Mtg. Guidance, Ben Bernanke is no threat to Wall Street.
When PIMCO's Bill Gross questions what's driving 10 year yields, alarm bells should be resonating LOUDLY somewhere within the FED. Yet, the remains silent and markets advance, oblivious to signals that have shaken past markets. Why is the FED silent about what's really driving ten year yields? Better yet, what's the purpose of the FED since AG personally saw to the total dismantling of Glass-Steagall? Is it to process checks & front run for Wall Street?
BB looks MORE ineffective and more disappointing with each passing day. When will Krugman, DeLong & the rest of our opining, reality-based, Republican-bashing Economists take him to task?
Here's the first question I'd ask him: Total repeal of Glass-Steagall monumentally and forever changed the way our financial sector conducts business. Why hasn't BB's FED recommended to Congress to bring regulatory control of our financial sector into the 21st Century to meet the new challenges before us?
PIMCO - Investment Outlook- December 2006 "Reality Check"
CR, do you think that some of the Fed's "hawkish rhetoric" on inflation might be actually due to the possibility of a falling dollar and not what they are seeing in their data on the economy? Most articles I see seem to be focusing on how the how the Fed is not reading the economy right so the market is discounting their warnings, knowing that they will have to drop the rates to stimulate the economy. Would it be possible that the Fed is reading a probable drop in the value of the dollar (along with other such issues like the housing bubble) as inflationary forces and are trying to support the dollar or at least moderate any sudden movements?
What got me thinking along these lines was the paper by Paul Krugman that cites his infamous "Wiley E. Coyote" theory on the lack of support for and possible drop of the U.S. dollar. And recently, Fortune noted that a falling U.S. dollar would put the Fed between a rock and hard place, having to choose between stagflation or stimulating the economy and having a plunging dollar.
Beware the falling dollar - Dec. 1, 2006
Economist's View: Krugman: Will There Be a Dollar Crisis?
How much of an impact could the falling dollar and the large amount of treasuries out there have in interest rates?
This issue I don't really have much grasp on. Namely, that a bailout from US treasuries across the globe could actually send rates up due to a glut.
It's raining dollars. Slosh, slosh, back they go into the market.
CR - an amateur question about fund rate probabilities if you'd be so kind ? How exactly do futures rates tell us what the expectations are ? Tried to sort thru the Cleveland web site and decoding that and the typical finance news escapes me.
Appreciate it.
Short term consumer debt 2.4 trillion
mortgage debt 10.4 trillion:
seems the consumer is locked into heavy debt on a long term basis, thanks to refi and home ATM. So just what would a lower overnight leanding rate do for consumer spending?
Ron, you're forgetting about the ARMs. Anything that resets at 12 or 6 month intervals "reprices" off the short end of the curve, not the long end. Also, when the cost of funds goes down, banks are irresistably attracted to the mortgage carry trade (in ARMs, that is). That could, I think, be enough to cause a cash-out refi boomlet, ceteris paribus--I am regularly told that there's enough equity out there for enough homeowners to support another one.
Tanta:
I thought ARM resets were based on either the 10 year or LIBOR guess I was wrong.
Thanks for the info
Andrew, thanks for the reminder about Krugman's excellent paper.
I think the Fed's hawkish comments are because they're truly more worried about inflation more an economic slowdown. That is also the consensus view of most on Wall Street.
As Krugman noted, if the dollar drops, the Fed's hands might be tied, not by the weakness in the dollar, but by any related inflation (imported goods cost more).
There are some very complicated interactions - if the U.S. slides into recession and drags the world along for the ride - China might sell U.S. securities to keep buying oil and hard goods to keep their economy out of recession. That might push U.S. rates higher - and complicate the Fed's job. I need to think about this some more - and reread Krugman's paper!
DaveL, I haven't worked through the math - I've just been taking the probabilities from the Cleveland Fed. So I don't think I can explain HOW they calculate the probabilities. Here is the paper that describes the methodology: Recovering Market Expectations of FOMC Rate Changes with Options on Federal Funds Futures. That should help with any insomnia!
Best Regards.
Ron, it's an easy mistake to make. Just remember that the 1 in 3/1, 5/1, 7/1, etc. refers to the frequency of ajdustment after the initial adjustment (which occurs after 3, 5, or 7 years). Because the loan adjusts every year, it has the duration of a one-year maturity. It is therefore indexed to something with a 12-month maturity such as a 1 year treasury (or a Constant Maturity Treasury, CMT, of 1 year) or a 1 year LIBOR. Actually, almost all subprime ARMs and a fair number of "Alt-A" ARMs have 6-month adjustments (2/6-month is very common), and are usually indexed to the 6-month LIBOR, although wackier 6-month indices exist. The Option ARMs are most frequently indexed to the Monthly Treasury Average, MTA, because they adjust every month (after any initial fixed period that might be offered), giving new meaning to the phrase "short end of the stick."
The initial interest rate of any ARM will, of course, be set with reference to the appropriately longer-maturity bond, option-adjusted and bond-equivalent effective margin applied, boatloads of discount points paid by desperate builders buying it down, etc.
A thought,
On the housing bubble, as it relates to the median purchase price:
This is looked to by the "housing optomists" to prove a leveling, flattening market.
But correct me if I'm wrong, this is only telling us how much people are willing to "borrow" to buy a house. It says nothing of the house value itself. Thus it's more a measure of affordiblity and the price of money...not the price of individual houses.
The old saying goes, you can buy the house, or you can buy the money to buy the house. Since the price of money is flat or dropping, I'm surprised we're seeing the drop in median prices we are. It is no where near the actual drop in prices for individual houses.
Unlike stocks, where the markets daily measure the relative cost of individual assets (stocks), the housing optomists point to what was spent or invested, not what was purchased. It would be equivilant to looking at the $ amount individual investors used to purchase stock and not how much or how little that money bought. How would you know if the stock prices were dropping or rising if you could only see the amount invested. Seeing Joe Investor bought a million dollars worth of stock last month, and this month Jane Investor bought anther a $million worth of stock...ie the market is flat?
My guess is that buyers first figure out how much they can afford and then go out to find the most house for the money. When the formally $500,000 house comes into the affordability $400,000 price range of a prospective homebuyer, he makes the purchase because it's a deal. No matter what, he was gonna spend $400,000 if he bought because that is what he can "afford" He just gets more for his money.
Now, does this not make perfect sense?
People look at the supply and demand and wonder how prices can stay so high. It seems understandable that those who do decide to buy do so with today's lending standards and "get as much as they can afford". i.e. flat purchase prices. Yet look around, prices on individual houses...if they even get bought.....are dropping buy huge percentages.
This matters to the individual home owner. But does it matter to anyone else?
Does anyone see that the bubble is not the price of homes but simply the amount people are willing to borrow to purchase an asset, no matter what form that asset takes.
And the bubble pops not when the asset is upside, but when the buyer cannot service the debt. Cars are bought and turn upside everyday. There is only a problem when you can't pay the car loan and can't sell the car. If the car loan is no problem, then the asset price is no problem.
Housing prices seem irrelevant when compared to ability to service the level of debt. If current debt levels are unserviceable, then a flattening median price of homes means more trouble for the economy, not less.
Am I an idiot?
In other words,
Those who decide to buy are going to buy as much as they afford....and since the price of money remains stable, the amount spent on homes remains stable.
Now YOUR home may have to be sold to someone planning on only spending $400,000 since that buyer willing to pay $500,000 can now afford the home that was $600,000 down the street.
Falling home prices, yet stable median home price sold. Apples and Oranges.
Tanta: excellent information-thanks agai
Am I an idiot?
No you are no idiot, but don't confuse the micro-logic of doing something with the macro-effects... they don't always behave in parallel... the might run off in different directions.
The institutions who lend that money (set the 'price' for that money) are deeply concerned about the value of those assets because they own thousands of those loans collateralized to them and a few always fail... so for them the fall back is in the valuations... if there is value there they can at least recover something.
Secondly the higher the valuations relative to the amount borrowed, the less likely the loans actually fail - the troubled owner has options if the LTV is quite a bit lower than 1.0, far fewer the as the LTV approaches 1.0 and none above 1.0 (think of it as 'one point oh-oh'.
So they DO care about the valuations and not just that a particular borrower is paying on time.
This concern will, in a healthy market, result in higher prices for credit and act as a feed back restraining the riskiest practices... you know the moral hazard thing.
I think the trillion dollar question is... "Is this a healthy market or is the market sick?"
I think we are all trying to get our head around that last question. AJ - you are more than welcome to add your thoughts & contribute to our group therapy sessions anytime.
Avg Joe, I've been thinking the same thing lately. That the median price number bandied about by pundits is not telling the whole picture of this market. I fully agree with your observation and subsequent analysis of this metric. Well put.
Tanta: couple quick questions.
Basically if the FED does cut overnight leading rates it only affects those ARM's not connected to a LIBOR. 2nd it seems the rate cut needs to be significant in order to help those facing resets?
ron -- the libor rate trades at a spread to treasuries about 25-50bp at the short end. The fed funds rate is actually closer to libor than overnight treasury because banks have worse credit than the govt.
Sharkbait brings up the other half of the issue, which is margin. Prime quality treasury-indexed ARMs generally have a margin of 2.75, so reset rate = index value + 2.75 (rounded to nearest .125, subject to per-adjustment caps). 2.75 is, then, the approximation of how much worse a credit risk an individual (secured) borrower is than the government. Prime quality LIBOR-indexed ARMs generally have a margin of 2.50, because this is the risk premium of an individual (secured) borrower over a bank. In theory, then, the Treasury-LIBOR spread is "captured" in the margin structure, so the final rate to the borrower on either loan is comparable.
The depth of the rate cut needed to make a difference depends, of course, on where you started (and what effect the rate cut has on the slope of the yield curve, which is where historical expectations battle "condundrums"). As with the significance of delinquency rates, its a matter of the vintage youre talking about. If you took a LIBOR-indexed 3/1 ARM in 2003, which a whole lot of folks did, your discounted start rate could easily have been 3.00%. If memory serves me correctly, 1Y LIBOR hit 5.00 around 36 months after the bulk of these loans originated, and they generally had 2.00% per-adjustment caps, so 5.00 index + 2.50 margin = 7.50, adjusted down to 5.00% by the caps for the final rate. (Most of the 5/1s and all of the 7/1s have 5.00% first adjustment caps, not 2.00%). A loan does not become "fully indexed" until its rate = index plus margin, without the effect of caps limiting the final number. Caps are, basically, the price the investor pays for mitigating credit risk (caps limit the damage of "payment shock" to the borrower).
Below:
Yield curve inversions are a bummer if they happen when your ARM happens to adjust. This is, of course, not "normal," but we certainly made and took ARMs as if it could never happen. Also, the "historical" performance of ARMs in terms of credit quality, prepayment speed, and post-adjustment yield approximation to "market" was based on the "historical" fact that people took ARMs when long rates were very high, in order to 1) get the initial discount or spread between initial ARM rates and the long fixed rate and 2) follow the market down without having to pay the cost of refinance. In 1985, when I got a 1/1 ARM with a start rate of 10.50%, that was a smart move. The whole equation gets hinky, though, when you have this phenomenon of record ARM origination during record rate lows (any rate, long or short). So put 1) discounted initial rate together with 2) origination at the bottom of the rate cycle and 3) inversion of yield curve at time of adjustment and you get the fact that a bunch of ARMs reset up as far as the caps allow at the same time that long rates were not a whole lot different than they were when the loan was originated. Insofar as borrowers took that 3.00% start rate back in 2003 because it was a great deal, they're either going to accept their current 5.00% philosophically or refinance into a fixed at around 6.00%. Insofar as they took the 3.00% because they barely qualified even with an interest-only payment, and they didn't get 10% raises in each of the last three years and their property taxes didn't stay at pre-boom levels, there's a bit of problem with refinancing into fixed, as there is affording staying ARM.
How deep does the rate cut have to go to bail them out? For some borrowers at the margin, it has to be deep enough to basically erase the risk premium, and "not gonna happen" sounds reasonable to me. If Fed easing causes a refi "boomlet," it is likely to be among those marginal ARM borrowers refinancing into another ARM, assuming that if they needed "nontraditional guidelines" to qualify first go-round those guidelines will still be there this time and that there's sufficient equity to allow them to roll financing costs into the loan and still be under 95% LTV or thereabouts. What I'm assuming here, with limited confidence, is that most people who want/qualify for a fixed rate already have one (refi booms do that) that will look like a good deal if Fed eases and long rates rise. That said, though, it's hard to predict how desperate people will be for cash-out; if we see low-rate fixed borrowers refinancing into ARMs for cash, we just have another consumer bailout that will need another consumer bailout (home prices or rates) in 3 years or so, absent certain fundamentals that rhyme with rising income.
And Ron is of course right to question how direct or uncomplicated the relationship is between cost of funds and short/long bond prices and hence mortgage interest rates. Duration/prepayment speed enters the picture; prime mortgages generally give the borrower a free put but Alt-A and subprime loans increasingly carry a prepayment penalty; rising long rates coupled with stagnating or declining existing home sales will extend the expected average life of mortgage loans generally and ARMs specifically from recent trends; all this coupled with upward pressure on risk premiums in light of current MBS performance will certainly complicate the impact of Fed easing, if and when it arrives, on mortgage rates.
And with that, I have finished both my store of wisdom and my first pot of coffee.
Thanks Tanta and Sharkbait!
CR - thanks, I think
. Insomnia definitely won't be a problem.Expectations calculas of Black-Scholes options pricing leading to multi-dimentional OLS estimates is not quite my idea of bedtime reading. But it would save on the Scotch toddies for sure.
More seriously the Fed may be between the devil and the deep sea because pressures on the $ would indicate a need to keep, or even raise rates. It'll be a matter of priorities and keeping offshore funds flowing given tat we're sneaking up to the edge of a cliff is more important than avoiding a 'mild' recession. That's actually true in a macro sense when you work out the consequences of each path.
Jim Jubak's column on MSN Money Central has a wonderfully straighforwad discussion with no B-S calculas thrown in.
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