CENAK Consulting - News and Views

Rate Freeze

So government decided to step in and announce a program to help homeowners that entered into ARMs with a rate freeze.  This move has to be seen as a purely political maneuver considering the upcoming elections.  In our view, it is the wrong signal and it might prolong the workout process for the housing market.  Further, for all those people that made sure they understood what they signed and that they could actually pay their mortgages, this is a slap in the face.  If anything, the government should take an active role in educating people early on in school so that they understand how this market works.  21 year old college kids who never saved a dime are buying houses these days.  Most of them have no clue about how to manage personal finances.  Start there and tackle the problem at its roots, the lack of financial education. Don't intervene in the market.  That sends the wrong signal to the markets and the people who might get the idea that the government will bail them out again in the future. 

25 or 50 basis points?

After todays ADP employment data and other indicators the jury is still out if te Fed next week is going to lower the Fed rate by 25 or 50 basis points.  As of today, my prediction is 25 bps.  But then again, we are waiting for important employment data on Friday.  If there is a weakness in the data, 50 bps might be more likely.  We shall see, for now my money is on 25 bps. 

Wall Street Bonuses

The WSJ reported the other day about bonuses on Wall Street this year, which will be significantly lower in certain areas than last year.  There is still no reason for bankers to complain as the average investment banker makes somewhat around USD2 million, according to the WSJ.  But that's exactly where the problem is.

In another piece, the WSJ wrote about the CDO and SIV mess a lot of the banks have gotten themselves into.  How could that happen?  A big part of this is how bankers are being compensated.  Banks make fees on setting these vehicles up and bankers get bonuses based on those fees.  The problem here is that compensation is based on closing the deal, not on how successful it is down the road.  The investment bankers that advised Time Warner to merge with AOL received huge fees and bonuses, however the merger turned out to be a complete failure. 

The same holds true for innovative new products such as CDOs and SIVs.  They became the "flavor of the month" and banks couldn't get involved in them quickly enough.  They generated fee income and the involved bankers where awarded huge bonuses, attracting even more people and companies to get involved.  Unfortunately, a lot of these banks did not appropriately assess the underlying risk.   Why?  Because people see the fees that can be made and the bonus that will get them based on selling these products, not on their long-term success.

This has always been a problem with investment banks and will remain to be a problem unless someone comes up with an idea how to force investment bankers to have more skin in the game.  Unless that happens, CDOs and SIV will repeat themselves in a few years, just under different names and with different people involved.

Write-downs and no end in sight

The positive unemployment numbers this morning surprised analysts, however the stock market was up only briefly until we heard further bad news from a Deutsche Bank analyst about potential write-downs by banks and brokerages to the tune of USD10 billion that are yet to come.

It is hard for me to understand why people would sign mortgages without understanding the full commercial consequences.  In my view, that is at the core of the problem.  Sure, there was probably predatory lending out there and some mortgage brokers may have based their advise on their own fees rather than the interest of their clients.  And yes, anybody who ever sat through a closing knows that the amount of documents you have to sign is ridiculous.  However, how can it be that people sign mortgages without taking the time to understand the full commercial consequences? 

I hope that we do not swing from one extreme to the other now, as it happens so often in this country.  We had little oversight over the mortgage lending business which at least partially contributed to this problem, I admit that much.  However, I am afraid that if politicians get involved the pendulum will swing far - too far - to the other side and put even further downward pressure on the already beaten up housing sector.  So let's please leave politicians out of this as much as possible and ask ourselves how this can be avoided in the future. 

People taking out mortgages that they full understand with all of the short-term and long-term consequences would be a good start.  As such, I would like to see a single sheet of paper at closing or even before that explains exactly the commercial terms of the loan.  If it is an adjustable rate loan, I want to see on that sheet of paper the payments if interest rates rise, fall or stay the same.   It should also outline what happens if the market value for the house drops by 10% or more.  How much equity is left and what is the worst-case scenario if interest rates go up and values go down?  All of these questions should be answered on a single, easy to understand sheet of paper.  Yes, it would add to the paperwork you'd have to sign, but understanding the commercial terms should be the most important factor when buying a house, and it appears many people didn't in the past. 

As to the crisis in the banking sector, that will work out itself.  In my time at investment banks I  experienced several similar cases where banks jumped on hip new products only to find out later that they didn't really fully understand the exposure they had with these products.  What does concern me is that we are still dealing with off-balance sheet exposures that investors do not get information on how to value.  In fact, even the banks don't know how to value them.  Still, in this case I do see a need for action from the governing bodies to make sure these vehicles are disclosed in the filings.  It is disturbing that even six years after the Enron experience we are still dealing with off-balance sheet items that investors do not know how to value.

Let's hope next week will bring better news.  We'll be back on Monday.  Have a good weekend everybody.

Recession, Stagflation ahead?

As much as I would like to talk a little bit more about CENAK and our services during this first week of our blog, there is just too much happening on the economy front this week that deserves commenting.

Today, the Index of US manufacturing fell to 50.9 in October from 52.0 in September.  A reading below 50 suggests contraction and the index is coming awfully close to that number.  Secondly, the mortgage foreclosure numbers for the third quarter nearly doubled from a year earlier.  Further, several bank stocks were downgraded.  As we reported here yesterday, investors still do not have confidence in the numbers banks are reporting and for now they are taking a pessimistic approach.  Thus, the market spiraled down today significantly in fears of a recession.

At the same time, oil prices today are still well above $90 per barrel.  Some analyst mentioned that we might be looking at stagflation, a time with low or no growth (stag-nation) and higher prices (in-flation).   I am not sure if I share this view, however we are certainly looking at low growth for the fourth quarter. 

What is saving the economy for now are the relatively low unemployment numbers that we are still enjoying.   However, they have been rising slowly but surely and some comments suggest that their importance for the overall economy may be lower than in past decades.  Nevertheless, tomorrow's unemployment data will be closely watched and we will be here to comment on it. 

Fed cuts interest rate

The Fed today decided to lower the interbank interest rate by 25 basis points. We have not seen many Fed decisions in the past that have received more mainstream press than today's. Why?

The decision today effects a large number of people personally.  A large number of homeowners are looking at their mortgages adjusting soon. The current mortgage crisis effects almost everybody in the US and even outside, where banks have to take write-offs from repackaged mortgages they hold on their books, so called Colateralized Debt Obligations or CDOs. The entire effect of the mortgage meltdown is still not know because CDOs are not a liquid assets like a stock. Banks have a lot of room for interpretation when it comes to valuing these assets on their books, just ask Merrill Lynch.

All of this goes directly back to the consumer, who is having an increasingly difficult time to secure mortgages for houses, or to refinance.  Consequently, home prices are falling and that effects almost everybody.

Today's move is sensible and may help the liquidity (read: debt) issues. But the Fed rate is a short-term rate and may not have much of an impact on long-term mortgage rates. That remains to be seen. What strikes me is how long this rate cut had already been priced into the markets.  As such, the independence of the Fed's decision needs to be examined. How much leverage does the Fed still have when the market practically dictates what it needs to do, and what not? 

One other aspect often overlooked is the impact of the decision on the dollar. Lower interest rates mean less demand for dollars, as investors rather put there money where they can earn more for their deposits. The dollar is at historic lows and predicted to loose further in value against the main currencies such as the euro or yen. That works against the Fed decision today as a low dollar potentially means higher inflation, something the Fed is still keeping a weary eye on.

Still, I think today's decision is a sensitive one as the economy is going to slow down.  Today's GDP number of 3.9% for the 3rd quarter is higher than expected, however it is widely expected for GDP to be in the 1-2% range only in the 4th quarter.  Still, some risk for inflation remains. Just look at the price of oil.