Analytical Wealth

``Today's action is intended to help forestall some of the adverse effects on the broader economy that might otherwise arise from the disruptions in financial markets,'' the Federal Open Market Committee said in a statement after meeting today in Washington. The central bank will ``act as needed to foster price stability and sustainable economic growth.''

Stocks surged, two-year Treasury notes rose and the dollar fell to a record low against the euro. The larger-than-forecast reduction suggests Chairman Ben S. Bernanke is prepared to leave himself open to criticism that he's rescuing investors from bad decisions for the sake of saving the six-year expansion.”

The  first thing that jumps out at me from the above passage is the phrase “bad decisions”, after all, that’s what led us here, bad decisions, not high interest rates. Furthermore, lower interest rates won’t magically erase the consequences of those bad decisions. So, what happens when investors begin to receive Q3 earnings reports (and later on) Q4 earnings reports and still see the impact of those bad decisions reflected in the earnings of the financial sector? What happens when financial sector earnings growth slows to a halt or even contracts YoY, because the earnings of the banks are no longer inflated by the real estate boom?

I’ll tell you what happens, you get a “let down”.

Investors are expecting that the rate cut will rescue the markets, and judging by the post rate cut surge they’re putting their money where their mouths are; but what happens when the results they’re expecting aren’t reflected in earnings, in foreclosure rates, in the real estate market, etc? The markets want “something” to return us to 2005, with respect to the credit markets, real estate, etc, however, due to the damage that has been done, money lost, investors burned, confidence shaken, stricter lending standards, etc, it’s not going to happen. Considering the events of the last 6-8 months, why would you want it to return to 2005, knowing that it’s a house of cards that’s destined to fall?

Moving ahead we’ll have investors suffering from a post rate cut “let down”, things won’t really get better and the Fed will continue to cut rates, until the market semi-organically recovers from the bad decisions, figures things out, etc. The Fed isn’t truly solving anything, instead, it is merely applying a “confidence salve” until the markets are able to recover on their own, just with a little help from “Uncle Ben”.

Another aspect of the rate cut that should be discussed is the idea that the rate cut will help the housing market or provide relief to home owners who are facing ARM resets and/or foreclosures. I hate to be the bearer of bad news, but it’s my belief that the rate cut will have a minimal impact on the ARM reset/foreclosure situation. I’m basing this on a quick analysis you can see below, I have two charts that look at $300k and $450k mortgages respectively, with ARM reset bands (based on the rate cut) of 9.75% à 9.25%, 8.75% à 8.25% and 7.75% à 7.25%, the chart indicates the savings within each band due to the rate cut, (as well as between bands with 50 basis point differences, e.g. 9.25% à 8.75%) as well as the difference between the teaser rate and the reset rate.

As we can see based on the charts above, the real problem is the difference between the teaser rate and the reset rate, since the cost savings from 0.5% rate decrease is somewhere between $102-$165 depending on your interest rate and loan amount. I seriously doubt so many home owners are going into foreclosure over less than $165/month, because they could either use credit cards, borrow from family, work extra hours, cut back on household expenses, etc, to make up the difference.

The real reason so many homeowners with ARMs are going into foreclosure, is because most people just bought as much home as they could afford at the teaser rate. Just think about how ARMs are often marketed: “You can borrow more money if you select an ARM”, in effect the bank is stating explicitly: “we’re going to lend you more money than you can afford at the reset rate and/or rate you would normally qualify for”.

Finally, the fact remains that anyone facing foreclosure is behind on multiple payments, not a couple hundred dollars short and in many cases, simply have a mortgage they can’t afford (for a variety of reasons) regardless of whether or not they have a exotic or traditional mortgage. Additionally, ARMs often come with reset intervals, so even if a small decrease in your payment is all you need, you may need to wait until the rate re-adjusts to see the cost savings. Banks may be even more willing to work with home owners now that rates are lower, but it’s no guarantee.

Analysts shouldn’t portray the rate cut as a savior of struggling home owners (or the housing market) because it does nothing more than to spread false hope. Generally speaking the rate cut won’t help those in danger of foreclosure, ease ARM reset pain, turn back the clock on the various factors that inflated housing prices and address the problem of rising inventories.  

Whilst the rate cut will buoy investor confidence and cause a short-term rally in the markets, it can’t save the housing market or make-up for the consequences of bad investment decisions.

At this juncture, the questions offered are as follows:

1. How long before the markets wake-up and realize nothing has really changed?
2. What will be the cost of this and (likely) future rate cuts? There is no free lunch and there is always a cost for central bank intervention; will the cure be worse than the disease?

You can read the entire text of the Bloomberg article on the rate cut here

Sources:

• Bloomberg – “Fed Lowers Rate to 4.75 Percent, First Cut Since 2003” – September 18, 2007