Economic Insights

I. Capital markets and economic update
The past week saw continued stability in MBS markets, but continued deterioration in the economy. The markets seem to believe that the Fed and OFHEO have halted the seemingly endless downward spiral in MBS prices. Through its Bear Stearns bailout, the Fed has provided credible evidence that it will do whatever is necessary to prevent a major financial institution from collapsing.

• FNMA MBS yield spreads over Treasuries maintained their recovery from the previous week and actually closed the week on the tight end of the recent range (see Chart 1 at the bottom of this email).
• Lehman Brothers easily sold $4 billion of equity, putting an end to speculation that it needed capital and would have trouble raising it.
• Non-farm payrolls and continuing claims signaled further employment weakness (Charts 2 and 3).
• Treasury rates declined as an already pessimistic market was unpleasantly surprised by the unexpectedly weak payroll numbers.
• The spread between LIBOR yields (what banks charge each other) and Treasury rates remained well above "normal" levels, indicating that banks are still in survival mode (Chart 4).
• Fed Funds futures indicated that the market no longer expects 75 or 100 basis point cuts in the Fed Funds rate after all the liquidity measures taken in March. Before this week's employment data, the market expected a 25 bp cut at the Fed's April 30 meeting; afterward, the odds of a 50 bp cut improved (Chart 5).
• A clearer picture of "conforming jumbo" FNMA MBS and jumbo FHA MBS execution began to emerge, with relatively positive initial signs.
• Foreign interest in U.S. agency MBS and agency debt increased to a record level.

II. How much risk-taking should be allowed?
A big-picture theme starting to take shape is government's role in determining how much risk to allow back into the system. As I've said before, risk-taking needs to resume in order for MBS spreads to recover lost ground and mortgage rates to drop. (For an explanation of the relationship between MBS spreads and investor risk, see the section entitled "FYI" located at the end of this email.) In practice, the "right" amount of risk-taking in the system is decided through a balance of self-policing market forces and government regulations. Today's reality, however, is that the balance is likely to tilt toward regulation.

The dilemma facing the Fed is that the tools they're currently using — reducing short rates and making it easier for financial institutions to borrow money — have a nasty side effect of encouraging what might be called excessive risk-taking. However, they don't have much choice. Since low mortgage rates are a vital part of a housing recovery, they can either continue to promote leveraged purchases or buy MBS themselves.

Back in the Greenspan Fed era, we saw the unregulated development of what some call the "shadow banking system" — hedge funds and other investors in the alphabet soup of CDOs, CDS, SIVs, and other financial innovations. Unhindered by the regulatory oversight that governs banks, these new lenders were free to take as much risk as they liked. In the process, however, they became so large and so intertwined with banks that their failure put the regulated banking system at risk. In another macro development last week, Treasury Secretary Hank Paulson proposed to change the structure of market oversight by giving the Fed broader power over a wider array of financial institutions.

This massive a change may take some time to put in place, especially in an election year, but his proposal is a sign of current thinking on a subject that has an enormous impact on the amount of risk-taking in the system. Its message seems to be that if the Fed is going to be held responsible for cleaning up after the party, they want more of a say in who gets invited and how crazy things get.

Where will we end up? I certainly don't know the "right" amount of leverage in a financial system as complex and interconnected as ours has become. But any teenager who's used bad judgment can tell you that the price is almost always less freedom and more rules. The entire financial system recently suffered a major lapse in judgment, and we'll probably lose some freedom to determine for ourselves how much risk is the "right" amount. Increased regulation and oversight, along with what may well be significant changes in the models used to quantify risk, will lead to capping the amount of leverage in the system at some level lower than in recent years. The most likely result is a sustained period in which the cost of consumer credit will remain higher than in 2005-06.

III. Housing: what's being done to slow the fall?
As home prices continue their slide, even investors who have access to leverage are reluctant to assume risk. Using FNMA and FHLMC as proxies for many would-be MBS investors who are still able to freely issue debt, you can see in the chart below that despite historically attractive MBS yields relative to their cost of funds (the line), these two GSEs actually have reduced their MBS holdings (the bars). Why? Because they need to raise capital to cover credit losses in the "g-fee" business resulting from falling home prices. Other investors are equally concerned that attractive MBS yields may be booby-trapped by further losses due to accelerating depreciation.

Lawmakers have devoted much attention to slowing the rate of defaults and foreclosures, with no fewer than eight housing rescue plans being discussed at the federal level and countless more in the states. Of the federal solutions, the two that seem to have the most momentum are sponsored by Rep. Frank and by Sen. Dodd. Both plans focus on heading off foreclosure so people can stay in their homes. For borrowers in trouble, participating lenders would forgive a portion of the existing loan equal to the difference between the old loan and 90% of the home's current market value. A new loan with a current LTV of 90% would replace the old loan. Who would make these new loans? You guessed it: the FHA.

The Senate plan that actually made it to the floor for debate last week was a scaled-down compromise providing, among other bits and pieces, tax benefits to home builders and homeowners buying foreclosed properties. If the Frank plan reaches the House floor in its current form, it would provide $300 billion in FHA funds for workout loans. Its major flaw is relatively broad eligibility requirements, which may encourage borrowers who can afford their payments to purposely default in order to reduce their debt. The Frank plan tries to prevent this by requiring that the original DTI be greater than 40% and by limiting the borrower's ability to participate in any future appreciation.

Some critics of these forgiveness plans will insist that they're a waste of taxpayer money, since there's no way to ensure that they reach borrowers at greatest risk of foreclosure. Others will argue that "bailing out" people who took more risk is unfair to those who were more prudent. These are reasonable arguments, but no plan can be perfect; and the consequences of no plan at all may cost a great deal more.

FYI: The inverse relationship of leverage to MBS spreads
The rate spread between MBS and risk-free instruments might be considered a sort of inverse temperature gauge of the amount of leverage (i.e., risk) in the financial system. More leverage makes MBS spreads go down, while less leverage allows MBS spreads to increase. Here's an example:

Say the yield on MBS is 6.50% and borrowing the money to buy them costs me 6.0%. Therefore, my "spread" is 50 bps. If I borrow 90% of the cost of the MBS, the return on my 10% equity will be 11%:

(100% * 6.5%) – (90% * 6.0%)
10%

If I'm able to borrow 95% of the cost, increasing my leverage from 10:1 to 20:1, I can buy twice as much and my return on equity will rise to 16%:

(100% * 6.5%) – (95% * 6.0%)
5%

But if everybody else does the same thing, demand for MBS will increase and (assuming the supply remains constant) the yield spread will tighten. Instead of 50 bps, it will be something less. As we saw in 2005-06, more leverage in the system did cause spreads to tighten, mortgage rates to fall, and housing to become more affordable. Sadly, it later became clear that so much leverage was too much of a good thing.

Chart 1 – FNMA MBS Yield Spreads to Treasury Yields

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Chart 2 – Non-Farm Payrolls

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Chart 3 – Continuing Jobless Claims

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Chart 4 – Libor vs. Treasuries

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Chart 5 – Fed Funds Probability Distribution for 4/30 Meeting

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