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     Oct 27, 2007
The Fed's knife is poised
By Peter Morici

The economic news this week was mostly discouraging. The risk of recession can no longer be placed below 50%. The economic fundamentals, though deteriorating, indicate the situation is salvageable, but the depth of structural problems in the mortgage market, and hence new home market, indicate aggressive action is needed from the Federal Reserve Open Market Committee when it meets next week, to help avert calamity.

In September, new home sales and prices did pick up from

August, but those still remain at woefully depressed levels. Housing starts continue to plummet at an alarming pace, and existing homes sales, which account for about 85% of all homes sold each month, turned in a very disappointing performance.

The median sale price for an existing home has fallen every month since June, from US$229,200 to $211,700 in September. Inventories of unsold homes keep climbing, and now top 10 months' supply. The real inventory is much larger as many homeowners, who would like to sell now, are sitting on their hands until conditions improve.

The market for higher-priced homes is in shambles, because even buyers with good income and credit histories have difficulty obtaining reasonable financing terms for mortgages above the Fannie Mae limit of $417,000.

Conservative economists like Fed chief Ben Bernanke counsel resistance to raising the mortgage cap for federally-sponsored banks, because they believe it would encourage reckless lending. That causes less doctrinaire minds to ask "What on God's green earth do you think has been going on these past few years?" How could jumbo lending by regulated federally-sponsored banks not improve the overall quality of lending and underwriting?

The losses on Wall Street and in the portfolios of mortgage banks now appear much larger than previously expected. This week, Merrill Lynch took an $8.4 billion write down on its mortgage-backed securities - that comes to 13.7% of its market capitalization - and the damage may prove much larger than this first estimate.

Once again, closing the barn door after all the animals are gone, the ever-prescient Standard and Poor's lowered Merrill's bond ratings. However, S&P's senior management will tell you their econometric models of future mortgagee behavior are dandy contraptions for forecasting default rates, and just some tweaking is in order.

Meanwhile, problems emerged in Countrywide's portfolio of prime loans. Aggressively marketed adjustable rate mortgages (ARMs) were sold to creditworthy homebuyers who could not make the payments on reset interest rates if home prices fell, which they did. Now delinquencies on Countrywide's portfolio of prime mortgages are rising.

Last week, Citigroup's super conduit - the Single-Master Liquidity Enhancement Conduit - was launched. It should provide some needed help to banks whose structured investment vehicles hold solid mortgage-backed securities, whose values are being artificially pulled downed by the nervousness in credit markets created by subprime-backed securities. However, this contraption is only a sticking plaster. It could buy the big Wall Street banks some time, but it will not provide the necessary reforms to get the economy firing on all cylinders again.

The economy can't function properly until the mortgage market is resuscitated, and that will take structural reforms and greater accountability for the players through the whole lending process, including mortgage brokers that process applications, investment banks that bundle mortgages into securities, bond rating agencies, home appraisers and mortgage servicing companies.

Treasury Secretary Henry Paulson, like Bernanke, seems to have near-infinite faith in the market to regulate behavior, and is moving dangerously slow. The reluctance to implement real change at S&P and other rating agencies, and at the boards of directors at Citigroup, Merrill and other venerable Wall Street institutions, indicates self interest is trumping common sense, and some federal intervention is needed.

Elsewhere, durable goods orders tanked, thanks to poor showings in the defense and transportation sectors, and the Federal Reserve Beige Book indicates generally slowing economic activity throughout the economy.

To buy some time, the Federal Reserve needs to act decisively and cut interest rates further, take some creative steps to pull down the long end of the yield curve, and indicate its commitment to continue aggressive actions until the mortgage and commercial paper markets stabilize.

Many homers stuck with ARMs and bedeviled by reset interest rates could be transitioned into long-term fixed rate mortgages if bank and mortgage company borrowing costs were lower. Even homeowners whose mortgages exceed the resale prices of their properties could be assisted if mortgage rates fell 50 or 100 basis points. The Fed needs to act decisively to make that happen.

Peter Morici is a professor at the University of Maryland's Robert H Smith School of Business, and a commentator on economic and political issues.

(Copyright 2007 Peter Morici. Used with permission.)

Empowering the fruitcakes (Oct 26, '07)

Subprime fallout: Save Our Souls (Oct 23, '07)

Vox populi: Why the Fed did a U-turn (Oct 17, '07)

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(24 hours to 11:59 pm ET, Oct 25, 2007)



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