Rates are in free-fall on news of an outright decline in August payrolls, and big downward revisions of the June and July reports.

Agency conforming mortgages are down to 6.25 percent, jumbos still sticky near 7 percent, and no change in availability: high-quality Alt-A still very pricey, as is any high-LTV lending.

I think the economic pattern is clear. For the last five weeks we have been in an uncontained credit crisis — not a “liquidity” problem, but an evaporation of balance-sheet value exposing lenders, forcing fire-sales of collateral, and a sharp contraction of credit availability. The economic effects of this crunch lie ahead; it is far too soon for them to have undercut August payrolls, let alone June-July.

The payroll weakness is a separate event, a pre-recession signal all its own. Other data indicate considerable forward inertia in the economy, notably the twin surveys by the purchasing managers’ association in August. However, a contraction in hiring is the definitive change, leading a general slowdown, leading layoffs, and marking the moment of diminishing inertia.

Now two strong forces will reinforce a third: the worst housing recession in a long time made worse by a credit panic; the credit panic spreading into a global affair far beyond mere mortgages; and the credit panic now getting its own shove from behind by an independently developing recession.

The Fed has either missed it all, misunderstood it all, or has no idea what to do about it. Yesterday’s all-OK brigade of Fed speakers look … say it: incompetent.

The Fed has tried for five weeks nothing but liquidity injections appropriate for a transient economic emergency, the ’87 Crash, for example. This is neither a transient emergency nor a single-firm threat like LTCM in ’98; we and the Fed have a systemic problem growing worse.

Examples: The president of the European Central Bank, Jean-Claude Trichet, last month announced its intention to raise its rate this month; yesterday he cancelled that intention and reduced forecast growth. One tough cookie in London, Holger Schmieding of BofA, said that Trichet made it clear that risks were far greater than the forecast reduction implied. Global risks: banks from Canada to Europe no longer trust each others’ credit, bank-to-bank loan spreads widening toward lock-up.

The best indicator, the “TED” spread (short-term U.S. Treasury rates versus unsecured Eurodollar ones): Bloomberg reports opening to 2.4 percent, the widest since 1987 and on a percentage basis I think may be the widest ever measured.

What to do: As argued here, the only ways to stop a credit panic are 1) to let it burn itself out, 2) to mobilize government guarantee or re-underwriting transparency, or 3) cut the Fed’s overnight rate as much as necessary, future inflation risk be damned, hoping to stay “ahead of the curve” but not too far.

#3 is all that’s left, unless some #1 miracle should appear. #2 … they don’t have the brains or reaction time for.

So, in utterly self-interested glee, I am looking forward to the imminent rescue of housing outside the bubble zones, and a reduction of damage there. I don’t know how deeply the Fed will have to cut its overnight rate (that will depend on the credit-panic/recession reinforcing spiral), but the 100-basis-point cut suggested two weeks ago by alert parties … today looks like about half of what’s coming.

It may take more weak data early in October to do the trick, but it is reasonable to expect fixed mortgages in the fives shortly, a boost to buyers and an escape for those who need a refinance escape. Better yet, ARM indices will drop tick-for-tick with the Fed, reducing re-set damage. Even though this rate decline may go deep, the advice here as always: take any deal that works, immediately.

If panic fades, the bond market and Fed will reverse in an instant.

Lou Barnes is a mortgage broker and nationally syndicated columnist based in Boulder, Colo. He can be reached at lbarnes@boulderwest.com.

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