October 3, 2013 Update

DJIA:15,133 S&P 500:1,694 NASDAQ:3,815 Gold:$1,309 Oil:$103.67 EURO:$1.36 YEN:97.77

Keeping the System Solvent

The American housing finance system has collapsed twice over the past three decades. The most recent and memorable crash was the one that ultimately led to the downfall of the entire global financial system in 2008. At the height of the crisis in 2009, Fannie Mae and Freddie Mac were put into conservatorship to protect the housing market and its’ investors. As the story is told, the two companies received $188 billion in bailout money from taxpayers in order to stay solvent. And it’s only because of the taxpayers’ money that Fannie and Freddie were able to make full recoveries and generate record profits in today’s bubbly market environment... or at least that’s the story central bankers want people to believe. The Fed wants consumers to think the market is rebounding. It’s their job is to restore confidence and encourage borrowing to fuel economic growth, regardless if its sustainable or not. And they’re doing a good job, so far. The housing market is showing signs of recovery. People are taking advantage of low interest rates and borrowing and building for cheap. But it’s not the current taxpayers that bailed out Fannie and Freddie, and it’s certainty not the demand for more housing units that are responsible for the recent signs of recovery. Unfortunately for both the housing market and its’ investors, the truth, like the economic recovery, is not as rosy as they are led to believe. When Fannie and Freddie were failing, the Federal Reserve ballooned its balance sheet and lent the companies money. The bailout was purely an accounting move that had relatively no effect on taxpayers of this generation. The burden of the bailout will weight more on the the future generations of taxpayers, not the working Americans of this generation. The government stepped in to save the GSEs, and hasn’t been able to step out yet. The US housing market is on life support. The majority of the funding for GSEs come from the federal government, they’re keeping the music playing in the markets. Before the government shutdown a few days ago, there was a flurry of activity in Congress that called for GSE reform. The Corker-Warner Bill actually proposes to wind down GSEs within the next five years, and turn the function of the secondary mortgage market back into the hands of the private sector by eliminating any government guarantee on most home loans. The government wants the private sector to bear more of the credit risk of the mortgage market, and make private companies more accountable for their lending decisions. Like the global financial system, the housing market is essentially a house of cards with nothing put faith, good luck, and gravity holding it together. The government will not be able to walk away from GSEs until long after the Fed raises interest rates, and the shock has been priced into the market (if that ever even happens). The Fed has skewed risk premiums and the government has encouraged borrowing, so a rise in rates could be the wind that knocks down the structure and blows the confidence out of the system while leading the American housing financial markets into its third collapse. Fannie and Freddie have a peculiar way of privatizing their profits and socializing their losses. A reform of the GSEs are definitely needed, but reforming without distorting the $10 trillion MBS market and exposing the country to the next Minsky Moment will be tricky to do, and whether the government will do so efficiently and properly is highly uncertain. All things aside, the Fed and the government together do an incredibly efficient job of manipulating the markets. I am sure that the choices made in reform will affect the availability, sustainability and affordability of mortgage credit for years to come, but I don’t think the Corker-Warner Bill will see the light of day again for a long while. And whether reform will even be possible without putting the country at risk for another recession is a question that has yet to be answered. 

Domestic News

• Market Update Future fall as the government moves into their third day of shutdown. 
• Data on the initial jobless claims will be released at 8:30 since it’s collected by the states, 313,000 are expected to have filled new applications for unemployment for the week ending 9/28, an increase from 305,000 in the week prior. 
• The ISM non-manufacturing index will be released at 10:00, and is expected to have slipped to 57.5% in September from 58.6% in August.

International Updates

Asia

• Market Update Markets traded mostly higher after upbeat economic data from China.
• China’s services PMI of 55.4 is a six-month high and contrasts with downbeat manufacturing PMI. 

Europe

• Market Update Markets were mixed with pressures from the US weighted on stocks while upbeat PMI data from the eurozone and U.K. eased tension 
• U.K. services PMI fell to 60.3 in September from 60.5 in August and the Eurozone services PMI rose to 52.2 in September from 50.7 in August, which sends more signs of recovery.