Juggling Dynamite

The WSJ today reports on the ongoing pressure that increasing lending rates are placing on the US consumer who is today more levered than ever before in history.  See Mortgage Rate Rise Pushes US Housing:

“The jump in 30-year mortgage rates by more than a half a percentage point to 6.74 percent in the past five weeks is putting a crimp on borrowers with the best credit just as a crackdown in subprime lending standards limits the pool of qualified buyers. The national median home price is poised for its first annual decline since the Great Depression, and the supply of unsold homes is at a record 4.2 million, according to the National Association of Realtors.

“It's a blood bath,” said Mark Kiesel, executive vice president of Newport Beach, California-based Pacific Investment Management Co., the manager of $668 billion in bond funds. “We're talking about a two- to three-year downturn that will take a whole host of characters with it, from job creation to consumer confidence. Eventually it will take the stock market and corporate profit.''

Confidence among U.S. homebuilders fell in June to the lowest since February 1991, according to the National Association of Home Builders/Wells Fargo index released this week. Housing starts declined in May for the first time in four months, the Commerce Department reported yesterday. New-home sales will decline 33 percent from 2005's peak to the end of this year, according to the Realtors' group, exceeding the 25 percent three-year drop in 1991 that helped spark a recession.”

Comment:  as one of the largest bond fund managers in the world, Pacific Investment Management Co (PIMCO) has a vested interest in encouraging rate cuts.  If we are into a cycle of systemically higher rates, this will prolong a bear market in bonds after many years of easy gains.  But Kiesel's concerns about the negative fall out of the housing recession are not to be easily dismissed.  The conundrum for the Fed is how to cut rates to help housing when inflation is above target and the US dollar is already falling.  The more the dollar falls the more inflation the US will suffer as their imported goods become more and more expensive to buy.  The imbalance of the past few years is now coming back around.

TD Institutional Services reports today that on Friday, credit-rating agency Moody’s cut the ratings on 131 bonds backed by pools of speculative subprime loans because of unusually high rates of default and delinquencies among the underlying mortgages (WSJ). Moody’s also said it is reviewing  247 bonds for downgrades, including 111 whose ratings it had just lowered. All the bondswere issued as recently as last year. The actions affect about $3.0 bln worth of bonds, representing less than 1.0% of the over $400 bln in subprime mortgage-backed bonds that were issued in 2006. However, some observers are critical of the rating agencies’ conflict of interest (issuers pay fees to have the securities rated) and the slow progress to address the housing downturn, with the downgrades coming well after market adjustments. So far more than 170 bonds backed by second-lien subprime loans, or about 18% of such bonds that Moody’s rated last year, have had their ratings downgraded.

Comments:  rating agencies have had their hand in the liquidity cookie jar with extra force this cycle.  Rating agencies are meant to be gate-keepers not just another part of the marketing machine. 

The WSJ today reports: Merrill Postpones Auction.  Merrill Lynch postponed its planned auction of $400 million worth of collateral assets from a troubled Bear Stearns Cos. hedge fund, giving the fund's managers additional time to present a plan for salvaging it.

“The problems of the fund are emblematic of broader turmoil in the subprime mortgage market, which has been hit by increased bond downgrades and rising delinquencies on underlying mortgages.

The Enhanced Leverage Fund, initiated last August, has roughly $600 million in invested capital, and has borrowed at least another $6 billion from Street lenders. From the start of the year through late April, the fund declined 23%, hit by a turnaround in the market for risky home loans that the fund had bet against…”

Comment:  more of this will follow.  Leverage is only our friend when prices are going in our favour.  For excellent perspective on this read: When Genius Failed:  The rise and fall of Long-Term Capital Management by Roger Lowenstein.