The Duration of the Interest Rate Freeze Looks Like Five Years

As time goes on more details are being leaked concerning the ARM teaser rate freeze. It is beginning to look like the duration of the freeze is going to be about five years. Also there is a lot of talk to make sure the bond holders are kept relatively whole and the threat of lawsuits is minimized. However, with all that said somehow I don't think the horse trading is over.

Also I still have not figured out who will pay for all this. I wonder if it will translate into higher application fees or interest rates for new mortgage applicants? Text in bold is my emphasis. From Bloomberg:

Federal regulators and U.S. lenders are focusing on five years as the duration of an interest-rate freeze on subprime mortgages, said a person familiar with negotiations aimed at fending off a jump in foreclosures.

Such an agreement would satisfy the shortest fix sought by the Federal Deposit Insurance Corp. That period is longer than the minimum, two- to three-year modifications suggested by Fannie Mae, the largest source of finance for American home loans. The Treasury Department's Office of Thrift Supervision advocated between three and five years.

``Fixing the reset period is an important action, and it's good that everyone now seems to be pushing in the same direction,'' said Michael Barr, a professor at the University of Michigan Law School and a former aide to Robert Rubin, who was President Bill Clinton's Treasury secretary from 1995 to 1999. ``Now the question is what additional steps are required to keep people in their homes and avoid foreclosures.''

Treasury Secretary Henry Paulson is finalizing the deal as the housing recession enters a third year, threatening the economic expansion. President George W. Bush and Paulson may announce the plan tomorrow, said two people familiar with talks. An administration official said on condition of anonymity that Bush will speak tomorrow on housing, without confirming details.

Officials and company executives spent much of the past week negotiating over how long to extend starter rates on subprime mortgages, which are usually given to people with poor or incomplete credit histories.

Representative Adam Putnam of Florida, the chairman of the House Republican Conference, said yesterday his interest in Paulson's efforts rose since he got calls from Florida officials about a state investment pool for local governments hit by debt downgrades. The state board froze withdrawals Nov. 29 to stem a run on assets. Rising mortgage defaults spurred billions of dollars in losses on securities backed by the loans.

``Florida in general increases my thinking that we need to look at the reasons to help mitigate the subprime meltdown,'' Putnam said.

Other Republicans expressed skepticism today.

``My biggest concern is that there are a lot of Americans who are making their mortgage payments, they are current, and the benefit won't go to them,'' Representative Spencer Bachus, the top Republican on the House Financial Services Committee, told reporters after the meeting with Paulson today.

One challenge will be to craft a deal minimizing lawsuits from investors in bonds backed by the mortgages being rewritten, analysts said. The longer that lower rates are extended, the more risk posed to the bonds' values. Republican Representative Mike Castle of Delaware has proposed legislation offering a ``safe harbor from legal liability'' to mortgage servicers.

``Within the contracts, there is room for the servicers to work with borrowers to minimize the loss for the investor,'' said Wayne Abernathy, executive director of financial- institutions policy at the American Bankers Association in Washington and a former Treasury assistant secretary.

About 100,000 subprime loans will jump from their discounted initial rates every month for the next two years, UBS AG estimates. American home foreclosures almost doubled in October from a year earlier as subprime borrowers failed to make higher payments on adjustable-rate mortgages, Irvine, California-based RealtyTrac Inc. said on Nov. 29.

These mortgages usually begin with a rate of 7 percent to 9 percent and then reset to between 11 percent and 13 percent. ``What we are talking about is having these loans modified, so they continue for a longer period of time at the starter rate,'' John Reich, director of the Office of Thrift Supervision, said in an interview in Washington Dec. 3.

Paulson and Fed Chairman Ben S. Bernanke are concerned that falling home values will choke consumer spending, which has driven economic growth since the last recession ended in 2001. By heading off further deterioration in the $11.5 trillion mortgage market, officials are also aiming to stem losses on securities backed by subprime loans.

Paulson said in his speech that the government is focused on helping subprime borrowers who can afford the introductory mortgage rate but not the adjusted one. The plan ``does not, and will not, include spending taxpayer money on funding or subsidies for industry participants or homeowners,'' he said.

Opponents to the Teaser Rate Freeze

Some of the biggest opponents to the teaser rate freeze are home owners and potential home owners. The excerpts below gives an abridged version of the article. The article has a number of anecdotes that are interesting perspectives on the entire teaser rate freeze idea. Text in bold is my emphasis. From the WSJ:

The Bush administration's plan to give subprime borrowers a break on their mortgages is already catching flak from an unexpected source: other homeowners.

Treasury Secretary Henry Paulson, at a housing conference yesterday, said he is "aggressively pursuing" an agreement with lenders and investor groups to freeze rates on subprime adjustable-rate mortgages at their original levels. The proposal, aimed at helping homeowners who would fall behind in their payments at higher rates, is designed to prevent a surge in foreclosures next year. About 1.5 million subprime adjustable-rate mortgages are scheduled to reset to higher rates in 2008.

But as outlines of the plan become known, some homeowners are complaining that the effort isn't fair to borrowers who didn't overextend themselves. Others argue that the government shouldn't be involved in perpetuating a housing bubble that needs to deflate. A key question: How far should you go to help borrowers who can't pay their bills?

"People have to be responsible for their own actions," says Harry Lancz, a small-business owner in Traverse City, Mich. He holds a pair of fixed-rate mortgages, one for his primary residence, which has been for sale for six months, and one for a second home in Louisiana. "What are you going to do when their credit cards get due and they can't pay? Are you going to bail them out on that, too?"

Like many homeowners, Mr. Lancz, 57, is skeptical that the plan will actually lessen the impact of the housing crisis. "Unless you give them the money, this is just postponing the inevitable," he says. "The more the government steps in, the more things get into a deeper quagmire."

The Paulson plan wouldn't help subprime mortgage holders who can afford the higher payments. In addition, it won't help those who can't manage to make their payments even at current rates. Because of that, some consumer advocates say the plan doesn't go far enough in helping troubled borrowers.

"This only deals with one of the easiest of the categories" of borrowers, says Mike Shea, executive director of Acorn Housing Corp., a national housing-counseling organization. "It will do nothing to help those people who are currently delinquent and facing foreclosure." Mr. Shea praises Mr. Paulson for trying, but points out, for example, that some mortgage-loan servicers already are freezing rates for five to seven years, so a grace period shorter than that in the government's proposal could be a step backward.

Proponents of the plan say it would prevent the housing sector from derailing the rest of the U.S. economy. In addition, they say that "predatory" lenders -- not just careless borrowers -- are responsible for the mess, and that homeowners shouldn't necessarily lose their homes as a result.

But some would-be homeowners who have been waiting for house prices to fall say the government proposal would prop up prices, and thus keep them out of the market. . . . .

A Little More on the ARM Teaser Rate Freeze

Every article gives a little more information about the ARM teaser rate freeze being pushed forward by Secretary Hank Paulson. Now they are suggesting using tax-exempt bonds to re-finance some of the mortgages. The article below is interesting because the full text makes the teaser rate freeze seem much more political. Text in bold is my emphasis. From the WSJ:

By the way, if you go to the original article at the online version of the WSJ you get to vote as to whether or not you think the teaser rate freeze is a good idea.

With two million borrowers in the U.S. expected to see interest rates jump on their adjustable-rate mortgages in the next two years, Treasury Secretary Henry Paulson urged the Democratic-controlled Congress to pass stalled housing legislation and support a new White House proposal to use tax-exempt bonds to refinance troubled subprime mortgages.

After months of criticism that he hasn't responded aggressively enough, Mr. Paulson implied that the administration was already doing all it could to stem the nation's mortgage woes, which have roiled markets, threatened many homeowners and raised the risk of recession. The secretary hopes the mortgage industry will announce this week an interest-rate freeze on certain ARMs.

Privately, Treasury officials say they don't have any major home-loan-relief initiatives in the works beyond those they have already aired.

Mr. Paulson's comments came as the president of the Federal Reserve Bank of Boston suggested in a speech that more than half of homeowners with subprime ARMs may be qualified to refinance into a less-costly loan by taking advantage of programs already available.

Boston Fed President Eric Rosengren said that 55% of borrowers with subprime ARMs for owner-occupied homes -- about 1.2 million homeowners -- haven't missed a mortgage payment in the past year. It is far from clear, though, that all of them could actually secure new mortgages. Some homeowners may have trouble refinancing, for example, because sharp declines in home prices have left them owing more than their houses are valued at.

Boston Fed research shows that 20% of borrowers with subprime ARMs nationwide should be able to refinance "relatively easily" into a prime mortgage or get into a loan-guarantee program, Mr. Rosengren said. At the time they took out their original loans, this 20% of subprime borrowers had relatively good credit scores, held at least 10% equity in their homes, provided full documentation of their income and assets and said they planned to live in the home.

In an interview, Mr. Rosengren said some borrowers with relatively good credit may have been steered into a subprime loan because it was more profitable for the lender. Other borrowers "who might have been considered prime based on their credit score" wound up in subprime loans because they didn't have adequate funds for a down payment, didn't wish to document their income or assets or wanted to buy a home that was more expensive than they could have qualified for, a Boston Fed study found.

Interest rates on as much as $362 billion in subprime home mortgages are expected to rise in the coming year, according to Banc of America Securities.

Treasury officials are urging the mortgage industry -- including lenders, loan-servicing companies and investors who own mortgage-backed securities -- to finalize a sweeping plan to freeze subprime interest rates. Mr. Paulson initially resisted such a proposal, but he has recently embraced it as the centerpiece of a market-based administration approach that also includes outreach and counseling for potentially struggling borrowers.

At the same time, Mr. Paulson, speaking at a Washington housing forum sponsored by the Office of Thrift Supervision, called on Congress to authorize state and local governments to issue more tax-exempt bonds over the next three years and use the proceeds to help strapped homeowners.

Even as the administration prods lenders to help troubled borrowers, Fannie Mae and Freddie Mac announced additional fees, or surcharges, that will raise the cost of some new mortgage loans. The surcharges, likely to be passed on to consumers, will affect certain loans purchased or guaranteed by the two government-sponsored mortgage companies after March 1. Some lenders already are starting to apply them, said Lou Barnes, a mortgage banker in Boulder, Colo.

The surcharges affect mortgage borrowers who have credit scores below 680, on a standard scale of 300 to 850, and who are borrowing more than 70% of the property's value. For instance, someone with a credit score of 650 would pay a surcharge of 1.25% of the loan amount for a mortgage to be sold to Fannie. On a $300,000 loan, that would mean extra fees of $3,750 for the borrower. That could be paid in cash or in the form of a higher interest rate than would normally apply.

Fannie and Freddie said they need to charge extra to reflect higher default risks, caused partly by falling home prices.

Looks Like the Fed is Finally Admitting That They are Worried

It is understandable that Fed cannot come out and state that it is time to head for the exits, it is better if they let it slide out over time. Given the markets propensity to panic, the Fed letting their beliefs out slowly is probably a good thing. Text in bold is my emphasis. From Market Watch:

San Francisco Fed President Janet Yellen said Monday that developments since the last rate policy meeting in October suggest a bigger slowdown than she has expected.

Yellen became the third top Fed official to suggest in the past week that further interest rate cuts might be advisable at the FOMC meeting on Dec. 11. It appears that any Fed officials arguing for holding policy steady are going to face tough sledding.

Last week, Fed Chairman Ben Bernanke and Vice Chairman Donald Kohn gave similar remarks suggesting that the financial turmoil in credit markets in recent weeks has raised the downside risks to growth in the next few quarters.

In her remarks, Yellen raised a red flag about consumer spending, suggesting that the long-awaited never-arrived slowdown in shopping may have arrived.

"It is far too early to tell if we are in for a sustained period of sluggish growth in consumption spending, but recent developments do raise the possibility as a serious risk to the outlook," Yellen said in a speech to a business group in Seattle on Monday.

"Recent data on personal consumption expenditures and retail sales are not that encouraging," she said. "They have begun to show a significant deceleration -- more than was expected -- and consumer confidence has plummeted."

Although there were also risks to the inflation outlook, Yellen said there are "signs of improvement in underlying inflationary pressures and core inflation should trend lower in coming years."

But it was the risks to the outlook that captured her attention. She reminded her audience that there is the possibility that "economic downturns can be difficult to reverse once they take hold."

"Since the October FOMC meeting, financial conditions have deteriorated, and we have seen some unexpected softening in the economic data," she said.

"For the next few quarters, there are signs that growth may come in somewhat lower than I had previously thought likely," Yellen said.

Yellen said it looks to her that the impact of the financial market turmoil that began in late July and August is beginning to slow the economy.

If this supposition proves correct, "a more prolonged period of sluggishness in demand seems more likely," she said.

Already, the fourth-quarter growth "is sizing up to show only very meager growth," Yellen said.
Nervousness by some banks about their capital may restrict lending terms and availability of credit, Yellen said.

"As yet, we do not appear to be at the point of an all-out credit crunch as we were in the early 1990s," she said.

Yellen said the renewed market turmoil over the past few weeks was a surprise. She said she expected a gradual recovery in credit conditions.

"At present, the ongoing turmoil in financial markets plays a crucial role" in the economic outlook, she said.

As a result, the outlook for housing has actually worsened, she said. Fundamental factors suggest that home prices have further to fall before the market finds its balance.

Yellen said not everything was bleak. She said the labor market has remained fairly robust and that further job growth was critical.

Who Gets Helped With the ARM Teaser Rate Freeze

As stated in previous posts (post #1 and post #2) the ARM teaser rate freeze is a bad idea, unless the banks are in much more trouble than people are letting on. Below is a summary of the group that would potentially be included by the teaser rate freeze. It is not that large a group. So now the question is who is being helped. Is the consumer being helped? Are the banks being helped? Or is this a bunch of political baloney to make the politicians feel good? We should know what we are buying because it will come at a cost. When you unilaterally change the terms of a bond Uncle Sam will destroy a lot of good will in the credit markets. Text in bold is my emphasis. From CNNMoney:

. . . .UI.S. Treasury Secretary Henry Paulson began to address efforts to stave off a foreclosure epidemic by lenders, those who service loans, and investors who hold mortgage debt.

Despite much speculation that Paulson is close to helping coordinate a rescue plan that would broadly freeze levels on adjustable mortgages before they reset to higher rates, Paulson gave few details on how such a plan would work.

He did however say who the plan would help, and it would probably leave out a large number of homeowners stretched by their mortgage payments.

Paulson divided subprime borrowers into four groups. The plan would be most geared toward those who can afford the mortgage now but won't be able to after the adjustment.

The other three groups are largely left out: Borrowers who can afford an adjustment; those who are already behind on their payments; and those who can refinance into a fixed-rate loan.

According to the Mortgage Bankers Association, 5.12% of outstanding loans were in default in the second quarter, a rate about 17% higher than a year ago.

The plan would also seemingly exclude borrowers who hold option-ARMs that aren't subprime. These are loans that start with extremely low "teaser" rates before rising dramatically a few years into the loan.

It has also been reported that homes that were bought as investments - as opposed to for the purpose of living in - would be excluded.

More than 50% of the increase in delinquent mortgages are actually investor-related, said Wachovia senior economist Mark Vitner. "It's hard to conceive how many people are actually going to meet this criteria. There's nothing at all in there that addresses investors," said Vitner, who added he doesn't support an investor bailout.

The group that will be helped represents just a narrow slice of the subprime borrowers in trouble, said Michael Shea, housing director of the Association of Community Organizations for Reform Now (ACORN). "It helps. Don't get me wrong. ... But it's disappointing that we are nearly a year into the crisis and the Treasury Secretary is dealing with the easiest part of the problem."

"It won't help the majority," said Lisa Rice, vice president of the National Fair Housing Alliance, a national organization dedicated to ending housing discrimination. "It's only going to help that one bucket, and it's hard to say how large that bucket will be without knowing the details of how the Treasury Department will assess affordability."

What tools would be available to the other groups? Paulson said that the Administration would recommend that state and local organizations extend their programs to help stretched owners refinance into fixed-rate mortgages. He also pointed to proposed modifications to the Federal Housing Administration that would make FHA loans, which can be more affordable, easier to get.

The limited scope of the plan has caused some consumer advocates to ask if it goes far enough.

Convention in the lending industry is that a family can afford to spend 28 percent of its gross income on housing. But an index put together by the National Association of Home Builders and Wells Fargo suggests that most homeowners spend more than that.

According to the NAHB-Wells Fargo Housing Opportunity Index, only 42 percent of homes sold in the third quarter were affordable to households earning the nation's median income. (The problem with the percentage oftentimes are open, but un-used credit cards. If a borrower has un-used credit limit of $10,000 this gets thrown into the calculations. Before you go for loan approval you need to close un-used or seldom-used credit cards.)

If the government relies on mortgage counseling programs and state- or city-backed bailouts to address the rest of threatened homeowners, the foreclosure problem might get worse, said John Taylor, president of the National Community Reinvestment Coalition.

A Blast From the Past – The Yield on 10-Yr Treasuries is Approaching the Inflation Rate

This is a very interesting discussion of what happened in the 1970s when the inflation rate exceeded 10-yr Treasuries. I remember that time. You borrowed as much as possible. Well, we are within 1/3 % of that today.

Hmmm, I wonder if a period of negative real interest rates along with a need for instant gratification is where the American public obtained its propensity to borrow? Text in bold is my emphasis. From Bloomberg:

For only the fourth time since Gerald Ford's presidency, oil is threatening to push the rate of inflation above 10-year Treasury yields. For bond investors basking in the biggest bull market since 2002, that's bad news.

Yields on 10-year notes fell as low as 3.79 percent last week, within a third of a percentage point of the consumer price index. Every time inflation has exceeded what investors get paid to own Treasuries, bonds have plunged. That happened from August 1973 through August 1975, when Ford addressed the nation with his ``Whip Inflation Now'' speech, and from January 1979 to October 1980, the end of Jimmy Carter's term.

``It's like the 70s,'' said Jim Rogers, a former partner of hedge fund manager George Soros who predicted the start of a commodities rally in 1999. Rogers said in an interview in Singapore that the rise in oil reminds him of when climbing fuel costs almost three decades ago caused 10-year yields to soar.

``We're in a period of a commodity bull market and inflation,'' Rogers said. ``I would not buy government long-term bonds. We'll be going down for years to come. Commodities are telling you to sell Treasuries. Inflation is everywhere.'' He holds positions that will benefit if Treasuries fall.

During the 1970s the 10-year note's yield, which moves inversely to its prices, rose to 12.4 percent by 1981 from 5.89 percent at the end of 1971. Normally, yields average 3.8 percentage points more than inflation, based on trading since 1987. Even if the relationship just reverts back to the 2.2- percentage-point average in the first half of the year, investors in 10-year notes would lose 0.8 percent.

``The inflation story going forward is going to be very different than what we've seen in the past,'' said E. Craig Coats Jr., co-head of fixed income at Keefe, Bruyette & Woods Inc. in New York, who began trading bonds in 1969 at Salomon Brothers. ``The inflation news is going to be worse.''

The yield on the benchmark 4 1/4 percent note maturing in November 2017 was little changed today at 3.94 percent, according to New York-based bond broker Cantor Fitzgerald LP.

Investors have sought Treasuries as a haven from widespread losses in mortgage markets even as consumer prices climbed 3.5 percent through October, the most since August 2006. U.S. government debt has returned 9 percent this year, including reinvested interest and price gains, the most since gaining 11.5 percent in 2002, according to Merrill Lynch & Co. data.

The combination has left the Federal Reserve with the dilemma of either cutting interest rates next week for a third time since September to prevent the housing slump from pushing the economy into recession or keeping rates steady to fight inflation. (It is worth the price of admission to stand around and watch this for the next 12 -24 months.)

``You've got to be thinking inflation is falling by a dramatic amount'' to buy bonds at their current yields, said Thomas Atteberry, who manages $2.3 billion in fixed income assets at First Pacific Advisors LLC in Los Angeles. ``I'm a little hard pressed to see that with the price for oil and the prices we're seeing for food. It's unsustainable.''

The central bank highlighted inflation concerns when it lowered its target for overnight loans between banks by a quarter point to 4.5 percent on Oct. 31. ``Readings on core inflation have improved modestly this year, but recent increases in energy and commodity prices, among other factors, may put renewed upward pressure on inflation,'' the Fed said in its statement.

In emphasizing so-called headline inflation risks, the Fed is including the impact of rising food and energy prices, which are more volatile than other items tracked in the index and usually excluded from the central bank's projections.

Fed Chairman Ben S. Bernanke signaled ``renewed turbulence'' in credit markets may have shifted risks between growth and inflation during a speech in Charlotte, North Carolina, on Nov. 29, adding to speculation the central bank will cut rates again. Financial futures traded on the Chicago Board of Trade show that there is a 68 percent chance the Fed lower rates at least a quarter of a percentage point on Dec. 11.

The average price of a barrel of oil was $6.87 in 1974, 77 percent higher than in 1973, according to the U.S. Energy Information Administration. The average price of crude tripled from January 1979 to January 1981 to $28.81, agency data shows.

Keefe, Bruyette's Coats said his forecast for faster inflation is based on demand from China, India and other emerging-market economies for oil and other commodities, demand that wasn't there in the 1970s. Global growth presents investors with ``a very different scenario'' than earlier periods, he said.

In October 1974, one month after appointing Alan Greenspan as his chief economic adviser, Ford urged the U.S. to conserve energy and increase productivity to overcome acceleration in the consumer price index, which reached 12.1 percent that month. The 10-year Treasury yield ended the month at 7.8 percent.

``I say to you with all sincerity that our inflation, our public enemy number one, will, unless whipped, destroy our country, our homes, our liberties, our property, and finally our national pride, as surely as any well-armed wartime enemy,'' Ford said.

Ford also drew attention to a button on his lapel with the letters WIN for whip inflation now. ``It bears the single word WIN,'' he said. ``I think that tells it all.''

The Misery Index, created by the economist Arthur Okun, an adviser to President Lyndon Johnson, is the sum of the unemployment and inflation rates. The index peaked in June 1980 during the Carter administration, when the jobless rate reached 7.6 percent and consumer prices rose 14.4 percent.

Both instances of negative real yields in the 1970s were caused by the central bank's unwillingness to tackle rising prices by raising rates, said Lyle Gramley, a Carter economic adviser from 1977 until he was appointed a Fed governor in 1980.

Carter's appointment of Paul Volcker to head the Fed in 1979 was an acknowledgment of the severity of the economy's problems, Gramley said in an interview. ``There wasn't any alternative other than very tough monetary policy.''

Volcker ended up boosting the central bank's target rate to 20 percent in 1980. Should real yields swing into negative territory it will be a ``unique'' consequence of the flight to quality, Gramley said.

Citi Economist Forecasts Fed to Cut Fed Funds Rate by 100 bps by June

While there are a whole group of analysts wondering if the Fed is going to cut rates this month, there is another group that believes that the Fed will end up making fairly large cuts over the next 12 months. Text in bold is my emphasis. As you will see from my comments (not in italics), there are parts of the article I do not agree with. From Market Watch:

By the way, bps (pronounced bips) stands for basis points and is financial speak for percentage. 25 bps equals 0.25%, so 50 bps is one-half percent, and 100 bps is 1%. Therefore, 1 bip equals 0.01%.

The Federal Reserve will cut interest rates by 100 basis points before June to help the housing market, Citigroup's chief economist, Lewis Alexander, said on Monday.

Alexander, who worked at the Fed before joining Citi, also said Asian economies would probably suffer only a modest slowdown as a result of the U.S. housing turmoil as the spillover effect from housing was much smaller than from sectors such as information technology.

"When the tech bubble burst, there was a substantial amount of capital and employment that had to be worked off," he said at a talk for Citi clients in Singapore.

Citi, he said, expected the Fed to cut its Fed funds rate by 25 basis points when it meets later this month and by 50 basis points in the first quarter of 2008. The final 25 basis-point cut would probably take place in the second quarter.

Alexander said the Fed would not be too concerned that the drop in the dollar would be inflationary. Studies carried out over the years had shown that the dollar's value had little impact on consumer prices in the United States, he said. (Does this guy shop for groceries or buy gas?)

"The vulnerability of inflation to a weaker dollar is not a major risk."

The dollar's fall from its peak in 2002 had had only a minor impact on inflation in the United States, he said, noting U.S. retailers were facing intense pressure to lower prices rather than raise them.

He also said a weakening dollar had not resulted in a general aversion to U.S. assets, noting Treasuries had rallied in recent months and equity markets had stayed relatively firm. (This is due to a flight to quality resulting from a credit crunch and nothing to do with a drop in the value of the dollar.)

Citi does not expect the United States to fall into recession as energy prices are unlikely to rise from current levels as the global economy slows. The anticipated Fed rate cuts will also help calm the housing and credit markets, he said. (Energy prices do not need to increase to get a recession, staying where they are is not helping the consumer.)

According to a Citi report on November 21, the dollar was expected to decline to 1.57 to the euro in the first quarter of 2008 before recovering to end the year around 1.47. The euro bought around $1.4660 on Monday.

Recession in 2008? – Heck of Way to Start Monday

Businesses are becoming increasingly pessimistic about 2008. Basically, falling profit, less capital spending, and more layoffs are going to be the rule for Q4 and at least the first part of 2008. So the corporate earnings recession is here. With a recession in corporate earnings, housing, auto sales, computer technology, etc. and with problems in the job market, the question becomes: how long can the consumer hang-on. Text in bold is my emphasis. From Bloomberg:

Slower sales and higher energy and labor costs are forcing companies from Bear Stearns Cos. to Pitney Bowes Inc. to reduce spending and hiring. Their efforts to keep earnings from eroding even further raise the risk that the economy, already weakened by the steepest housing slide since 1991, may shrink sometime next year.

``The earnings recession has already arrived,'' says David Rosenberg, North America economist for Merrill Lynch & Co. in New York. ``We are going to see an economic recession in '08.''

Corporate profits, as measured by the Commerce Department, fell at an annual rate of $19.3 billion in the third quarter from the second, as domestic earnings dropped by $41.2 billion. The drag from sagging U.S. sales and huge writedowns offset robust earnings abroad, fueled by the weak U.S dollar. The fourth quarter may be an even bigger bust.

``In the third quarter, the tide shifted, and for the worse,'' says Joseph Quinlan, chief market strategist for Bank of America Corp. in Charlotte, North Carolina. ``The domestic- profits squeeze is in its early stages and will be severe enough to overwhelm strong foreign earnings.'' . . . .

. . . . Profits for the Standard & Poor's 500 companies fell almost 25 percent on a per-share basis in the third quarter, the biggest year-over-year decline in almost five years. David Wyss, S&P's chief economist, expects their earnings to fall as much as 30 percent in the fourth quarter as companies take more writedowns for bad investments. Excluding such extraordinary items, operating profits may fall as well, he says.

Even if profits have peaked, that doesn't mean the economy is about to turn down, says Steven Wieting, managing director of economic and market analysis at Citigroup Global Markets Inc. in New York. In the last expansion, profit margins began contracting in late 1997; there was no recession until March 2001.

What's troubling this time is that much of last quarter's damage came in the financial sector, where operating earnings fell 25 percent, as banks and brokers were hurt by losses from subprime mortgages and related investments. Analysts' estimates compiled by Bloomberg indicate the industry's profits this quarter may decline more than 25 percent.

The plunge in financial profits is a triple whammy for the economy as banks and other institutions pare payrolls, cut capital spending and become stingier with loans.

Bank of America, JPMorgan Chase & Co., Bear Stearns, Citigroup Inc., Lehman Brothers Holdings Inc. and Morgan Stanley have announced some 25,000 job cuts so far this year. Gustavo Dolfino, president of New York executive-search firm Whiterock Group LLC, said in a Nov. 20 interview he expects them to fire thousands more. . . .

. . . . Claims for unemployment benefits jumped to a nine-month high in the week ended Nov. 24. Economists polled by Bloomberg forecast that data to be released Dec. 7 will show payroll growth slowed to 70,000 in October from 166,000 in September, while the jobless rate rose.
``We see a significant slowdown in the growth of jobs and equipment spending in 2008,'' says Allen Sinai, chief global economist for Decision Economics in New York.

Orders for non-defense capital goods excluding aircraft, a proxy for future business investment, fell 2.3 percent in October, the most since February, according to Commerce Department figures. . . .

. . . . . The biggest hit to the economy from fading financial profits may come from tighter lending standards. The Federal Reserve reported last month that banks were making it harder for businesses and consumers to borrow. Analysts including Sinai expect terms to tighten further. (This is going to be the real problem.)

``Higher delinquency rates will continue for some time,'' Chief Executive Officer Dennis Alter told analysts. ``What is not clear is where the economy and consumer behavior is headed.'' . . . .

. . . . . Foreign companies are starting to feel the fallout from weakness in the U.S. -- a reversal of the recent trend, in which American firms benefited from strength overseas.

Stockholm-based Ericsson AB, the world's biggest maker of wireless networks, said Nov. 20 that fourth-quarter sales may be at the lower end of a forecast it gave a month earlier as demand falters in North America and Europe.

The next day, Wolseley Plc said it will cut 1,300 jobs in the U.S. after the decline in homebuilding led to a 15 percent fall in profits at the world's biggest distributor of plumbing and heating equipment.

``Looking out over the next 12 months, the U.S. is going to be very challenging,'' Chip Hornsby, chief executive officer of the Reading, England-based company, said on a conference call.

The Plan to Freeze Teaser Rates on Some Subprime Loans has Resistance from the Investors

How would you like it if you were a bond holder and Uncle Sam stepped in and unilaterally cut the interest rate on your bonds. What do you think your bonds will be worth going forward? When is the next time you would be willing to buy one of these bonds? How much faith will you have in bonds issued by private companies going forward?

Now assume that you pay all your bills on time. Furthermore, assume that you have an ARM and you have positioned yourself in such a way that you can continue to pay the mortgage when the ARM resets, after all that is the deal. Assume the guy across the street has exactly the same deal as you do in terms of ARM resets, price of home, and income, but he is basically a “screw-up” when it comes to handling his money. Because of a recent government policy his teaser rate is frozen, but yours is not. You acted responsibly and the guy across the street did not and you are being punished. How are you going to feel?

The question I have for Mr. Paulson is why are you meddling in the markets? Or are things so bad in the mortgage markets that if you do not meddle in the markets, the banking industry comes to its knees? Why does this sound like the 21st century version of FDR's "banking holiday" of the early 1930s?

I give - what am I not seeing.

See previous post on this issue. Text in bold is my emphasis. From the WSJ:

A government-led plan to freeze interest rates on certain troubled subprime home loans drew criticism both from investors who foresee losses and from some analysts warning that it will merely prolong the pain of the mortgage crisis.

As much as $362 billion in U.S. subprime home mortgages with adjustable interest rates are due to reset at potentially higher rates in the coming year, according to Banc of America Securities, risking a wave of defaults by borrowers unable to afford the new monthly payments. That in turn could exacerbate a wave of write-offs by investors who now own those mortgages. Losses related to bad mortgages already have reached the tens of billions of dollars and have led to turmoil in the world's financial markets.

Fears that the problems could accelerate have led the U.S. Treasury and the mortgage industry to develop a plan that would postpone the higher rates for some borrowers.

The success of the plan, details of which are still under discussion, may hang on the many investors in securities backed by mortgages. A coalition of lenders negotiating with the administration includes investor representatives, but the securities are held world-wide and it would be impossible to get everyone's approval. A deal could also spark lawsuits from investors who believe they're being cheated out of their money.

Unlike in years past, when just a bank and a borrower were involved in a mortgage, today's loans have been bundled together, sliced into securities and sold to investors. That has created problems for officials trying to help borrowers, because so many parties are involved.

Alan Fournier, a fund manager at Pennant Capital Management LLC, Chatham, N.J., predicted that the plan being pushed by the Treasury Department will prolong the pain of the housing slump. He said it would merely delay inevitable foreclosures for some people who can't afford their homes, while allowing holders of mortgage-backed securities to put off marking down their assets.

"This reduces the pressure short-term to bring everything to a clearing price," Mr. Fournier says. "We really just need to let it wash through."

Most subprime loans, which go to borrowers with poor credit records, carry an introductory "teaser" rate for two or three years before moving to a higher rate. The plan would keep the teaser rate temporarily for some borrowers.

The plan is being negotiated by the Treasury Department and a coalition of mortgage-industry participants, including lenders, mortgage counselors and servicers -- the companies that collect mortgage payments. Many of the particulars need to be worked out, including how long the interest-rate freeze would last and which subprime borrowers would be eligible for relief. . .

. . . . Still, the move is drawing criticism from some on Wall Street, who say the government shouldn't be meddling in the market.

"There's a part of this that's just morally repugnant. The problem is that the policy makers are talking to servicers about giving away other people's money," said Mark Adelson, a principal of Adelson & Jacob Consulting LLC, which consults on securitization and real-estate issues. "It's not the servicers' money, but shareholders' and investors' money."

Among those who stand to gain or lose the most in this plan are mortgage giants Fannie Mae and Freddie Mac. Their support would be crucial to the plan's success, because they are viewed as standard-setters in the mortgage industry. Both are members of the coalition. If they endorse the Treasury formula for loan modifications, that would make it easier for servicers to defend themselves from any challenges by disgruntled holders of securities backed by the loans being modified.

Freddie owns about $105.4 billion of securities backed by subprime mortgage loans, and Fannie holds about $42.4 billion of such securities, according to their third-quarter filings. Those combined holdings account for about 15% of the $1 trillion or so of U.S. subprime loans outstanding, according to trade publication Inside Mortgage Finance. Other holders of securities backed by subprime loans include banks, insurance companies, mutual funds and hedge funds.

"Fannie and Freddie have a lot more to gain than to lose" from a program that reduces defaults and foreclosures, said Moshe Orenbuch, an analyst at Credit Suisse in New York. If modified loan terms can prevent some foreclosures and delay others, that might buy time for the housing market to begin to recover, he said.

A temporary freeze on troubled home loans may help stave off defaults, a plus for investors in mortgage-backed securities, but it would also reduce the amount of interest the loans are expected to pay.

Investors' losses are likely to depend on what type of security they own. Some own riskier slices of debt that may lose much or all of their value if a home goes into foreclosure. This group might benefit from a plan that puts off foreclosures. Other investors might lose less from foreclosures, so long as the foreclosed house can be sold for a reasonable sum.

"The tricky part is that...you have these investors who are all spread out, people owning different bonds and all different classes and changing the loans may affect different classes in different ways," said Alex Pollock, a resident fellow at the conservative American Enterprise Institute and the former president of the Federal Home Loan Bank of Chicago.

The American Securitization Forum, which is part of the coalition and whose members issue, buy and rate securities backed by bundles of mortgages, had been resisting broad modifications of loans. Now it appears to be backing the idea of standard criteria that could be used to help large swaths of troubled borrowers.

"Currently, we are striving to develop streamlined methods of segmenting borrowers with various characteristics," said Tom Deutsch, the forum's deputy executive director, in testimony before a House hearing in California yesterday.

Peter Haveles, a partner at the law firm Arnold & Porter in New York, said the agreements underlying issues of mortgage securities generally give the servicers discretion to modify loans if they consider that to be in the best interest of the holders of the securities. He said the possible litigation isn't likely to derail the Treasury plan, in part because of the breadth of the coalition negotiating it.

A bill introduced by Rep. Mike Castle, a Delaware Republican, would temporarily free servicers from any liability for modifying loan terms. "Investors are still going to get a return and it's in their better interest to have those loans perform rather than fail," Mr. Castle said. (If lawsuits are not a big deal as indicated above then why is this needed.)

Wow, The Congress Agrees That Car Makers Need to Have Vehicles with 35 MPG Average Mileage by 2020. What a Break Through.

I realize that Otto von Bismarck said that there are two things you don’t want to watch being made are “laws and sausage”. (The exact quote is, "Laws are like sausages. It's better not to see them being made.") But, give me a break, the new energy bill coming out of Congress requires that automakers have an average gas mileage rating of 35 mpg for everything they sell in 2020. If you drive a car in 2020 that gets less than 50 – 100 mpg you will not be able to eat. The law is nice, but I think the market will take care of this issue of gas mileage long before 2020 ever arrives. The interesting part of this bill is that 15% of electricity generation has to be from renewable energy by 2020. From CNNMoney:

Congressional Democrats reached a compromise late Friday to boost automobile fuel economy by 40 percent, clearing the way for a House vote probably next week on an energy bill that Democratic leaders would like to send to President Bush before Christmas. . . .

. . . . Automakers would be required to meet an industrywide average of 35 miles per gallon for cars and light trucks, including SUVs, by 2020, the first increase by Congress in car fuel efficiency in 32 years.

But Democratic leaders were stymied over disagreement on the auto fuel efficiency issues as Dingell, the longest-serving member of the House and chairman of the Energy and Commerce Committee, insisted on some provisions to ease the transition for automakers.

Sen. Carl Levin, D-Mich., who strongly opposed the 35 mpg requirement when it passed the Senate in June, endorsed Friday's compromise. It "will require new fuel economy standards that will be challenging for auto manufacturers," he said in a statement. "(But) we got concessions on some of the most important issues."

Under the agreement, the ability of carmakers to use production of so-called flex-fuel vehicles that run on 85 percent ethanol to offset some of the fuel efficiency increases would be extended five years, to 2014. Also, the new standards would be set on the basis of vehicle weight, giving manufactures greater flexibility to meet the requirements for SUVs and pickup trucks.

Still, the industry overall must achieve 35 mpg average, counting all vehicles, by 2020, compared with the current requirement of 27.5 mpg fleet average for cars -- a level that has not increased since 1989 -- and 22 mpg for SUVs, passenger vans and pickups.

She said the bill also will include a ramp up in the use of ethanol and other biofuels and a requirement for nonpublic electric utilities to use a minimum amount of renewable energy such as wind and solar to produce their power.

While details of those provisions were still being worked out, aides said the ethanol provision was expected to mirror Senate requirements for use of 36 billion gallons of ethanol a year by 2022, a sevenfold increase over today's productions.

Power companies would have to produce 15 percent of their electricity from renewable energy, aides close to the discussions said.

Both the Senate and House approved separate energy bills last summer, but Democratic leaders have struggled for weeks to try to work out a compromise acceptable to both chambers -- and garner the 60 votes needed to survive a sure filibuster in the Senate.

House Republicans have called the legislation a "non-energy bill" because, they said, it ignores any measures to promote domestic production of oil, natural gas or increased use of coal.

But Pelosi has said its aim is to turn away from fossil fuels toward development of renewable fuels and place greater emphasis on spurring energy efficiency and conservation.

She said the auto fuel economy provisions represent a "landmark ... that will offer the automobile industry the certainty it needs, while offering flexibility to automakers and ensuring we keep American manufacturing jobs and continued domestic production of smaller vehicles."

The agreement on vehicle fuel economy came after days of tense discussions between Pelosi and Dingell, a staunch defender of the auto industry, who had pressed for concessions to help the industry. Pelosi agreed to a number of Dingell's demands but stood firm on the overall requirement of 35 mpg, phased in over the next 13 years.

"The agreement reached today prescribes standards that are both aggressive and attainable," said Dingell. "We have achieved consensus on several provisions that provide critical environmental safeguards without jeopardizing American jobs."

Meanwhile it became increasingly likely -- though not yet certain -- that Democratic leaders will abandon attempts to repeal nearly $16 billion in tax breaks to the oil industry as had been approved by the House earlier this year.