In one of life’s larger mixed blessings, a return of financial panic is pushing mortgage rates lower. The approach to 6 percent is taking longer than I thought, but the week’s events make crossover to the fives more likely than ever.
Signs of slowdown are accumulating: Retail sales in October rose a meager 0.2 percent; new claims for unemployment insurance are now rising (slowly, but rising), and October industrial production slipped by 0.5 percent.
Half of the commentariat still insists that inflation is the real trouble, the economy is fine, and the credit markets will soon self-correct. Two Fed governors also made these points today (Poole and Kroszner). This flight to quality — 10-year Treasurys down to 4.14 percent this morning — has nothing to do with expectations of an easy Fed. At this point, the queasy sensation of a Fed out of touch with reality adds to the panic.
The stock and bond markets this week were overwhelmed by blown deals, probable bankruptcies, more write-downs pending, and cash running to safety. Even “safe” positions in commodities began to fail, gold in free-fall: this Crunch is deflationary.
Instead of a recitation of institutions and their woes, here is an example, a story to describe the peculiar nature of this Crunch and its consequences: the oddly wide spread between the 10-year T-note and mortgages.
Under normal historical circumstances, the 10-year should lead retail mortgage rates on a leash no longer than 1.5 percent to 1.75 percent. We’ve taught a generation of borrowers that wherever the 10-year goes, mortgages are sure to follow.
Since the onset of the Crunch in August, frightened money has gone to the 10-year, but mortgage rates have been sticky. For the last couple of weeks, the 10-year has been at 4.25 percent, and the retail rate for the lowest-fee 30-year mortgages has been stuck at 6.375 percent. A spread wider than 2 percent! Why?
Mortgages are toxic, but given Fannie’s and Freddie’s federal “Agency” credit and too-big-to-fail status, who should care? Almost all the Treasury/mortgage spread is compensation for the risk that you’ll refinance — nothing new there. And, if credit were the issue, Ginnies’ yield would be falling versus F&F; Ginnies are by statute “full faith and credit,” the same credit as Treasurys. The Ginnie/F&F spread is stable.
I posed the question to a kid running a trading desk (in his 20s, already a Master of the Universe). “There’s too much production for demand.” Son, don’t fib to an oldster: The production of mortgage-backed securities has crashed by two-thirds since August. “So? I said there was too much production for demand.”
By what mechanism in the midst of a flight to quality would investor demand fall faster than collapsing production? In all recent recessions, consumer demand evaporated and the Fed restored it by injecting liquidity. This predicament is unique (since the 1930s … heh-heh…): Capital is evaporating, and the capital is leveraged. Lose 10 percent of a stock market mutual fund and you’ve lost 10 percent of your money; if a bank loses 10 percent of its assets, it has lost everything — all of its capital.
The Fed can’t create capital. Only earnings over time, or sale of new stock, or raising subordinated debt can do that. If you’re losing money, new capital doesn’t want to join your busted party. To raise $2 billion in capital from BofA, Countrywide had to give an option on 17 percent ownership and pay 7.5 percent interest. Even on rich terms, capital injection is risky: BofA’s option is at $17, but Countrywide stock hit $12 this week.
If you are a bank or dealer with impaired capital, you can’t make new investments and may have to shed some that you have. Giant banks and dealers alone wrote off $50 billion in capital in the third quarter, and face a like amount in the fourth, more following. At 12:1 leverage, conservative for guaranteed-credit assets, that’s enough capital to have supported $1.2 trillion in Agency mortgage-backed securities.
That’s where demand went, and is still going. Fast. Nevertheless, panic is pulling Treasurys down enough that even at a wide spread, mortgages are going lower.
Lou Barnes is a mortgage broker and nationally syndicated columnist based in Boulder, Colo. He can be reached at email@example.com.