Saturday, February 23, 2008


Friday afternoon the story broke that Citibank, Wachovia Bank and others are in negotiations to re-capitalize Ambac, one of the mortgage loan insurance companies. The stock market went from down a little to up a lot in the last hour of trading. Is this Ambac story likely to be true? If so, what will the consequences be? WOW! The market is ready to move!

The story is likely to be true because it is in the best interest of the banks to snatch a share of ownership in this deeply discounted company while saving their own hide! Bank shares have fallen sharply but the mortgage insurers are down from the $80 area to the $10 area! Right now, banks hold billions of dollars worth of mortgage backed securities that have been written down to various levels of "cents on the dollar". This does not mean the assets are only worth "cents on the dollar". The reality is that the great majority of mortgages in America are being paid and will be paid at 100 cents on the dollar plus interest!

The insurance companies are, no doubt, the first line of defense. They are like cannon fodder on the battlefield and they will suffer each time an insured mortgage goes unpaid. However, the big decline in interest rates last month means the interest rate on most of these loans will remain near the original issue rate. Many a homeowner who has been frightened to death by the talk of soaring mortgage rates will be greatly relieved to discover that his rate is going to stay about the same.

Pundits who talk about the soaring foreclosure rate imply that the credit markets are in bad shape. On the corporate side, balance sheets have perhaps never been better. For the first time during my life, corporations are net savers! On the consumer side, consumer debt outstanding has come down as percentage of total assets for 4 years in a row. Bankruptcies are low, interest rates are low and employment is strong. To say that foreclosure rates are soaring is like saying that a rainy day after a prolonged drought is likely to make the dam break; lake levels rise quickly after the first rain but the size of the lake expands as the lake level rises so the second, third or fourth rains of equal amounts do not increase the water level as much as the first rain. The situation in the credit markets is that problem loans had gotten to very low levels so the recent problem did cause a big jump relative to the prior year but not a big percent in terms of total loans outstanding. To put it another way, during the recessions of 1973-74 and 1990-91 a lot of banks went belly-up but banks are in good shape this time around. Northern Rock Bank in England is the exception that proves the rule.

Yes, a lot of banks, hedge funds and insurance companies hold mortgage backed securities and there is little trading in this market. I submit that there is little trading because holders do not want to sell during a temporary down turn. If you were CEO of a bank holding securities that have a par value of $1,000 are paying interest on the $1,000 and are backed by insured mortgages that are by large measure being paid on time, would you be willing to sell for $600?

The recent whine has been that the two big mortgage insurance companies might lose their AAA rating which would limit the ability of banks to make new mortgage loans. The two big insurers, MBIA and Ambac, are solvent, they have the assets to honor their obligations. They do not have the assets necessary to maintain their AAA credit ratings. What if?

What if Citibank, WB and others were to invest enough cash into Ambac such that the AAA ratings would be secure. The billions of dollars worth of securities being held by these banks would appreciate back towards par value. The banks would once again be able to make loans to credit worthy borrowers who do not have 20% down payments available. Suddenly, pent up home demand would be released. Demand for homes would increase such that those struggling to pay would have greater incentive to do so and the option to sell would look more attractive as the price bubbled back up. Even the demand for foreclosed homes would be improved. In the past several months, 11 months supply of unsold homes has fallen to 7.5 months, even though the selling rate has been slow. In other words, the number of homes coming on the market has been less than the number of homes being sold. Speed up sales a little, and the unsold inventory will come down at a very fast pace and the "housing crunch" will be over. The psychology will have suddenly switched, on the buy side from "no need to buy in a hurry, home prices and interest rates are falling" to "we had better buy now while there are still bargains left". On the sale side, the psychology will switch to "lets wait to put our house on the market because prices are going up".

What if the pressure were suddenly off the FOMC to lower interest rates?

There is a strong possibility that a deal will be worked out this weekend to re-capitalize Ambac. A second group of banks, those who use MBIA as their insurance provider, will follow the Ambac lead. In other words, it is likely that the market will know that the mortgage credit crunch is over by next week and perhaps as early as Monday. With the credit crunch over, the rational for the FOMC to reduce short rates more will be "fini". The world wide economy is simply too strong for lower short interest rates if there is no longer a "housing crisis".

If the short interest rate cutting cycle is over, then the commodity surge is suddenly over. The price of gold, oil and other commodities should decline as soon as it is clear that the FOMC will once again focus on inflation. Once the price of gold turns, it will turn with a vengeance. Huge holdings of commodities have been sequestered as a result of commodities having become a "financial asset class". The gold ETF's must purchase gold in order to issue new shares in the fund. Once the shares are redeemed, the fund no longer has the funds to support the price of gold. Once this gold starts coming back on the market, the extra supply will reduce the price which will make more people sell shares of the funds. This feedback loop will not end until there has been a significant decline in commodity prices.


The steep drop in commodity prices will give the FOMC the ability to raise interest rates by doing nothing. The latest headline inflation rate of 4.3% combined with a fed funds rate of 3% leaves a real interest rate of negative 1.3%. People have been paid to hoard commodities. This is the reason you may have heard the stagflation word being bandied about. In the 1970's, the economy went through a prolonged and devastating period of higher and higher inflation rates and negative real rates. The fear is that we are now in or about to move into a similar period.

The fear is a reasonable fear to have if you listened to the latest Hillary -- Obama debate. The fiscal policies supported by Hill-Obama are essentially the same as the Johnson policies that got the prior wage-price spiral started. In fact, Hillary has even proposed a five year mortgage rate freeze which is similar to the ineffective Nixon responses to the problem. There is political risk of a return to stagflation, however, on the monetary side of the equation, we are no where near the failed policies of the 1970's. After Johnson decided to offer the nation both "guns and butter" by fighting the Vietnam war without funding the war with higher taxes, the FOMC "monetized the debt". This means the FOMC printed the money to pay for the war. Money is just like any other commodity, produce too much of the stuff and the value of the stuff must fall. By the end of the late 70's all money was "hot money", you needed to spend it today because it would buy less tomorrow. Good news: the FOMC has not been printing money to monetize the Iraq war. The money base has not grown hardly over the past 4 years.

Again, if Ambac and MBIA are re-capitalized, the housing mortgage market will quickly "return to normal". The housing crunch will be over and there will be no reason for the FOMC to increase the money supply or to cut short term interest rates. The psychological support for higher gold prices will be suddenly gone. Oil, gold and other commodities will lose a big chunk of inflation risk premium. Headline inflation will fall hard. Suddenly a 3% fed funds rate will represent a high real rate. High real rates will reduce the attraction of gold all the more. Oil and gold are routinely hedged by one another and they trade together. The decline in gold will be accompanied by a decline in the price of oil. The central bankers of the world will breath a sigh of relief as their job of holding down inflation will be much easier. Low inflation is on the other end of the stock market see-saw.