Policymakers Attempt to Stabilize Markets

MBA (9/22/2008 ) Velz, Orawin


Financial turmoil dominated financial markets last week. The week began with several dramatic events, including Lehman Brother's bankruptcy, the sale of Merrill Lynch and the threat that AIG could go bankrupt.

Once again, investors re-priced their risk and moved their funds, including those from money-market mutual funds, to safe-haven U.S Treasuries, bringing down the yields across the curve, with the yield on three-month Treasury bills dipping below a tenth of a percent.

The extent of risk aversion and the resulting liquidity crisis was reflected in the explosion in the TED spread—the difference between the three-month Libor and three-month Treasury bill rate. (Libor is the dollar-denominated overnight London interbank offered rate or the rate at which banks lend to one another). The significantly wider TED spread reflected market jitters and extreme levels of counterparty risks as it indicated that banks were unwilling to lend each other money and would do so only by charging a considerable risk premium.

Amid the crisis, the Federal Reserve held the federal funds rate steady on Tuesday but took extraordinary measures to inject liquidity into the global financial markets. On Wednesday, to relieve the pressure on the Libor market, the Fed boosted its U.S. dollar swap line with foreign central banks so that they could provide their respective financial institutions with short-term dollar funding.

These efforts did little to relieve liquidity pressure, however. The TED spread continued to rise to more than 300 basis points by mid-day Thursday. This was considerably higher than the spread seen in mid-August, 2007 of about 240 basis points and more than 200 basis points above its recent lows on September 5. The spread narrowed modestly on Thursday afternoon, as the stock markets rebounded in response to reports that policymakers were considering to create a new entity to absorb distressed and illiquid assets from the balance sheets of troubled banks.

The details of how such an entity will operate are being worked out as this is written. Congressional action will also be required. There will be many questions to be answered and a great deal of uncertainty involved. More immediately, as part of its broad plan to stabilize markets, the Treasury will double its planned purchases of mortgage-backed securities to $10 billion this month and may make more MBS purchases in coming months. Fannie Mae and Freddie Mac will also increase their purchases of MBS.

Economic reports, which took a backseat to the financial crisis, generally pointed to deteriorating activity. Industrial production fell sharply in August. The Conference Board's Index of Leading Indicators dropped in August for the second consecutive month, indicating a slowing economy ahead. Total housing starts dropped sharply in August, driven by declines in multifamily starts. Single-family starts fell modestly, but sharp back-to-back drops in single-family permits suggested further cutbacks in coming months. Continued pullbacks are necessary, however, to reduce the excess supply in the market given the huge overhang of unsold inventory in many parts of the country and soft housing demand.

While continued decreases in home sales are likely, near-term leading indicators suggested that the declines should be moderate in the coming months. Home builders reported that current market conditions and outlook for new home sales modestly improved in September, according to the National Association of Home Builders/Wells Fargo Housing Market Index. The index was up slightly from a record low, the first increase in seven months. Rising consumer confidence, declining mortgage rates and the first-time homebuyer tax credit helped lift builders' confidence.

The Mortgage Bankers Association Weekly Application Survey also showed that the purchase application index has steadily increased since mid-August as mortgage rates trended down. The increases in the purchase index paled in comparison, however, to the surge in the refinance index of 88 percent in the latest week following a 15-percent rise in the prior week.

Treasury yields dropped sharply across the curve through mid-Thursday, benefitting from a flight to quality. Stocks surged on Thursday afternoon and continued through Friday. Treasuries declined and yields rose as investors' risk appetite increased. The yield on the 10-year Treasury note stayed around 3.82 percent by mid-Friday afternoon, about five basis points higher than the rate on the previous Friday but 35 basis points higher than the rate at the start of the week.

With the turmoil in financial markets, the spread between the yields on 10-year Treasury notes and conforming fixed-rate mortgages widened to about 230 basis points, still about 40 basis points narrower than the gap seen before the announcement on Fannie Mae and Freddie Mac.

Housing and Mortgage Indicators:
The National Association of Home Builders/Wells Fargo Housing Market Index rose two points to 18 in September from 16 in August. The August reading matched the record low reached in July. (Readings below 50 indicates that more respondents view market conditions as poor.)

The survey asks builders for their sentiments on current sales, traffic of potential buyers, and projected sales over the next six months. All the three components improved over the month. The index gauging current sales conditions increased to 17 from 16 in August, while the index gauging traffic of prospective buyers edged up to 14 from 13. The index gauging sales expectations for the next six months jumped to 30 from 24—the largest one-month gain since April 2003 and the highest reading since April.

All four regions posted increases in September. The Northeast led the gain with a six-point increase, while the Midwest, South and West each posted a two-point increase.

Rising consumer confidence, declining mortgage rates and the first-time home buyer tax credit have combined to improve builders' confidence, according to NAHB. Nearly half of the builders in the survey expected to see a positive impact from the tax credit in their markets, while 20 percent already saw some of the impact.

Total housing starts fell 6.2 percent in August to a seasonally adjusted annualized rate of 895,000. Single-family starts dropped a modest 1.9 percent, reaching the lowest level since January 1991, while multifamily starts were down 15.1 percent, following a 26.8 percent plunge in July. Multifamily starts surged about 230 percent in June in the Northeast, reflecting a rush to start building activity before local building code changes took effect at the beginning of July. A huge decline in multifamily starts in the Northeast in July partially reversed that surge. In August, every region but the West showed sizable drops in multifamily starts.

Through the first eight months of this year, single-family starts were 39.7 percent lower than those in the first eight months of 2007. By contrast, year-to-date multifamily starts with five units and over were 11.2 percent higher than those last year. Year-to-date construction of structures with 2-4 units declined 45.6 percent.

Total permits fell 8.9 percent in August. Single-family permits—a leading indicator for single-family housing starts—dropped 5.1 percent following a similar drop in July. This marked the 16th decline over the past 17 months. The report also showed that the share of single-family starts intended for sale was about one third in the second quarter of 2008 (the rest were owner- or contractor-built units). This suggested that seasonally adjusted single-family starts intended for sale in August were around 420,000 units, well below the sales pace in recent months. Unless new home sales slip considerably going forward, the months' supply (inventory-sales ratio) should decline slowly from the current level of about 10 months.

Economic Indicators:
Industrial production—the nation's output from factories, mines and utilities—fell by 1.1 percent in August after edging up 0.1 percent increase in July. Manufacturing output dropped 1.0 percent in August, led by a plunge in motor vehicle and parts output. Business equipment production fell 0.6 percent—the biggest decline since April—driven by a large drop in transportation equipment production.

Utility output declined 3.2 percent, while mining output fell 0.4 percent. Capacity utilization fell a full percentage point to 78.7 percent, the lowest reading in four years.

The Consumer Price Index fell 0.1 percent in August after a 0.8 percent increase in July and 1.1 percent gain in June. From a year ago, the CPI was up 5.4 percent, edging down from 5.5 percent, which was the biggest year-over-year increase since January 1991. During the three months ended in August, the CPI has risen at an annual rate of 7.2 percent, compared with a 10.6 percent increase during the three months ended in July.

Excluding the volatile food and energy items, the core CPI rose 0.2 percent following a 0.3 percent gain in July. Over the past year, the core CPI was up 2.5 percent for the second consecutive month.

The Conference Board index of leading indicators—a gauge of future business activity three to six months ahead—fell 0.5 percent in August after dropping 0.7 percent in July. The index was at its lowest level since October 2004.

The Conference Board's index of leading indicators is designed to forecast economic activity and turning points in the business cycle based on 10 economic components. A decline in building permits led the decline.

The biggest positive contributors included positive Treasury yield spreads and an increase in consumer expectations. The six-month annualized growth rate slipped to negative 2.1 percent from negative 1.6 percent.

The index is down 3.7 percent from its recent peak in January 2006. During the 2001 recession, the index posted a 3.6 percent peak-to-trough decline. Over the past three months, the index fell 4.2 percent (annualized rate) suggesting that the economy has decelerated quickly.