More Rate Cuts to Come?

Bloomberg is reporting that the FED is certain to cut rates again before the end of the year:

"Government bond traders, who predicted six of the last seven recessions, say the Federal Reserve will lower interest rates again before the end of the year as the economy comes to a standstill."

Just to be clear, the FED is crazy to lower interest rates at a time when the United States' government depends so much on borrowing money from other countries. But the real question should be "How can a savvy investor use this information to make money?" Aside from gold and the gold funds that have previously been recommended, one way to take advantage of the prospect of lower interest rates is through American Century Tarket Maturity 2025 (BTTRX). Tim Middleton offers an explanation:

"The fund owns nothing but zero-coupon Treasury bonds maturing in 19 years, and therefore is a pure play on the direction of interest rates. If they are headed lower, as they would in a recession, this fund would soar."

The most savvy of savvy investors would have purchased shares towards the end of June; but that doesn't mean that tomorrow isn't a good time. The fund peaked at the beginning of September and has since dropped about five percent and appears to be gearing up for another shot up. And of course there's a very real possibility of a recession and more rate cuts, which make this fund worthy of consideration.

S&P, Moody's to Downgrade Subprime Securities - World Stocks Falter

Well, it's about time. How long has it been since we've known about the risks? Months and months. Finally, the two credit ratings organizations are coming around:

"Credit ratings on 612 classes of residential mortgage-backed securities backed by U.S. subprime collateral have been put on CreditWatch with negative implications, S&P said. Beginning in the next few days, the agency said most of these classes will be downgraded."

"That covers about $12.078 billion in rated securities, or 2.13% of the $565.3 billion in U.S. RMBS rated by S&P between the fourth quarter of 2005 and the fourth quarter of 2006, the agency noted."

Meanwhile, in a related story:

"Moody's cut ratings on 399 subprime residential mortgage-backed securities, or RMBS, and said that it may downgrade another 32 because of higher than expected delinquencies on the underlying home loans."

I don't know how many more securities there are that are at risk, but I would bet there are more. Any literate investor should have known for weeks of the great risk associated with subprime mortgage securities; the looming interest rate reset will be devastating. Here's the simple picture:

"A lot of debt will be downgraded to junk status. A lot of that debt will have to be sold at fire-sale prices. A lot of pension funds and hedge funds that once thrived on the high returns they could get from investing in subprime junk will now lose a lot of money."

"S&P's announcement is a death warrant for the subprime industry. No longer will mortgage brokers be able to help buyers lie their way into a home. Fewer stressed homeowners will be able to refinance their mortgage, thus extending and exacerbating the housing bust."

Unwinding this tangled mess is taking time; along the way, it will affect more than just the mortgage industry. Of course it has already hurt the homebuild sector. Higher foreclosure rates have contributed to a rising supply of homes; also, looser loans standards helped fuel a housing boom which assisted in creating future projections that were grossly inflated.
And the subprime mortgage fiasco has not and will not be kind to the banking industry. Depending on who's holding what, investors could be rewarded greatly for making the right bets.

Another sector that could feel the hurt is retail. Fewer homeowners refinancing mean less being spent at home depot or at the mall. We've already seen home depot's hurt. Bed Bath and Beyond has also lowered it's expectations in the last few weeks. The housing downturn might be blamed as the number one reason, but subprime is not far behind. And as the noose tightens around lending standards, the infusion of cash that has helped fuel earnings in retail will evaporate.

Today, just one day after flirting with a record close, the Dow faltered by more nearly 150 points. Following the Dow decline, Asian markets followed suit. Something will act as the catalyst initiating a world-wide economic slowdown. It could be subprime, it could be something else. All that needs to happen is for a spark to start the wheel spinning. The next couple weeks should give us a decisive answer.

Exotic Security Classes, Balloon Payments, and Prepayment Penalty

This quote (from an article I referenced in my last post) caught my eye:

"CRL also found that more than two thirds of the subprime loans it looked at contained prepayment penalties. By charging borrowers up to six months of mortgage payments to retire mortgages, prepayment penalties lock borrowers into onerous loans by making it very expensive to refinance out of them and into a lower-rate fixed."

Prepayment penalties are a result of a CDO market making every attempt to minimize risk. Let's look at a couple of exotic securities available: IOs (interest only) and POs (principle only). Consider the following example: Bank 'A' created $100 million worth of mortgages. The mortgages are for 8 years at 8% with a balloon payment at the end. The bank takes those debt obligations, pools them together, and sells them to an intermediary who creates different asset classes depending on the cash flow expected from the borrower. The two equations below outline the yearly payment plan for two different asset classes. The top equation is the payment schedule for the investor who buys an IO security; the majority of their return comes from the interest paid by the borrower. The bottom equation is the payment schedule for the investor who buys a PO security; the majority of their return comes from the principle payment in the form of the balloon payment at the end of eight years.

You may have noticed that 43.5 and 55.7 is 99.2, not 100. In the example, the intermediary takes 0.8 as payment for administering the asset classes.
Prepayment penalties on mortgages are meant to reduce the risk. In our example, when borrowers refinance, the owners of the PO security class get their return without having to wait out the eight years, but the IO class is left with a bad investment as less interest is paid, causing a declining return on capital. Conversely, when the borrowers extend their loan, the IO class reaps the rewards as they continue to collect interest, while the PO class is forced to wait for their return.
What happens when the borrower defaults on the mortgage? A portion of the security becomes worthless. When there are record defaults, these securities will have big problems.
There's much more default risk undertaken by the PO class as 87 percent of their return depends on the balloon payment. There's default risk with the IO class as well, but that risk diminishes with each successive year.
There are some hedge funds that are heavily invested in these types of securities. The companies operating them will be the ones that suffer tremendously as foreclosure rates increase further, and they will. The beginning of the great mortgage reset has just begun and with more subprime mortgages being issued, the problem will continue.
At the beginning of this post, I referenced a CNN Money article that described a subprime mortgage market who hadn't learned their lesson. The lesson won't be learned until we reform the CDO market. Much like the illegal drug industry, as long as there is demand for these types of exotic investments, there will be a supply of exotic mortgages.

Credit Check...

Total consumer credit outstanding has increased by 57 percent since 2000. Contained in that is revolving credit debt (ie: credit cards), which has increased 44.5 percent since 2000. Mortgage debt has increased 105 percent since 2000.
Going further back, we can see that total credit has increased 205 percent since 1990. Revolving credit debt has increased 315 percent over the same period of time. Finally, mortgage debt has increased 294 percent since 1990.
There have been articles questioning the effect that consumer credit may have on the economy since 2004. The bubble hasn't burst yet, but it's coming due. But how did we get here? Two rulings helped the credit card companies: 1978's Marquette National Bank v. First of Omaha Corp and 1996's Smiley v. Citibank.
In 1978, the Supreme Court ruled that credit card companies could charge interest rates based on the state laws where the companies were located. The laws where cardholders lived were circumvented. And guess what - the companies that issued the cards moved to Delaware and South Dakota and any other state willing to deregulate interest rates. Then, in 1996, the Supreme Court took it a step further and ruled that credit card companies could charge any fees that were allowable by the state law in which they were headquartered.
These two rulings completely deregulated the credit card industry and, when coupled with more stringent bankruptcy rules (implemented in 2005), are helping to usher in a new era of serfdom. Stay out of the pocket of the credit card companies or surrender as a virtual slave.

The beginning...

Welcome to my blog!

As I start this blog, general market conditions look bleak.
The housing market is in tatters; and still, people keep yammering about a rebound. It's not coming anytime soon. Interest rates have been rising constantly over the past few weeks, which means more loan defaults and an even greater supply of housing on the market. AND, a rise in interest rates means less people will be eligible for mortgages; thus, less houses will sell.
The stock market keeps making gains; Dow Jones record highs are a weekly event. I'm anticipating a market top in July. I like the week of the ninth as a target date. This year, the Fourth of July falls smack dab in the middle of the week; I don't believe that investors will shake their bullish attitude until after the holiday. I'm somewhat amazed that the market hasn't tanked sooner, especially with all the recent bad news. It's a perfect example of psychological factors trumping fundamentals; it's like faith trumping reasoning. Soon enough there will be a price to pay. Get out now while you still can.
Gold has been up and down this year. Hovering around $600 at the beginning of the year, the price of gold shot up to $690 around the middle of April. Currently, the price is $651.60.

Chart: http://www.thebulliondesk.com/

Looking at the five year chart reveals a distinct upward trend. At this point in time, I'd recommend buying gold due to the lull in price; it makes for a perfect jump in point. I expect that the price of gold will continue to rise through at least the end of the year.
Oil has been a bit volatile since the beginning of the year. On January 18, 2007, the price of crude was $50.20. Today, June 14th, oil traded at $67.69 per barrel; that's a 35 percent increase since the winter months. Seasonal cyclical patterns are apparent in the short term.
The long term will inevitably create upward pressure. There is a finite amount of oil in the world; because of it’s relative scarcity, it makes for a great economic topic. In 2007, the United States is consuming oil at the highest rate: 20,730,000 bbl/day. Compare that to China's paltry 6,534,000 bbl/day, a mere 31.5 percent of our consumption. There are 1.3 billion people living in China, compared to 301.1 million people inhabiting the United States. To put it another way, the whole of the population of the USA only amounts to 23 percent of the population in China. So what happens when their oil consumption catches up to ours? I recommend holding oil for the long term. If I had no position, I'd recommend seeing what happens in the next few months prior to jumping in; however, crude oil and oil stocks should see gains in the long term.

---EP