My latest thinking on ... well ... as much as I can fit in here
* What does the Fed cut mean? Well, some mortgage holders will see a smaller increase in the rates and payments on their adjustable rate mortgages. That’s because funds rate reductions are now lowering the London Interbank Offered Rate, or LIBOR, that many such mortgages are tied to.
JPMorgan analysts said that the cut could shrink the increase on subprime ARM payments to 8%, on average. Bank of America analysts note that if the Fed cuts to 2.5% eventually, payment increases could "disappear altogether." More details in this Bloomberg story.
Home equity line of credit rates will come down as well, because they’re tied to the prime rate. The prime rate essentially mirrors changes in the funds rate. On the other hand, savers will get the shaft again. That's because rates on Certificates of Deposit and money market accounts will likely fall in the wake of the latest cut. I've always respected the work Bankrate.com does, and you can get a product-by-product update of what the Fed cut means in a series of stories that start here.
* So that's good news for mortgage performance, right? Well, it certainly doesn't hurt. But rate resets aren’t the only threat to mortgage borrowers and loan performance right now. Falling home prices are a big deal, too (see this post for more details and a link to a Boston Fed study on the matter). The more home prices fall, the further underwater borrowers become, and the more borrowers just give up and walk away from their loans.
The latest S&P/Case-Shiller report showed prices falling 7.7% from a year ago in November. That’s the worst drop on record. Prices were down in 17 of the 20 metropolitan areas the firm tracks. And even cities that were reporting nice year-over-year gains are starting to fade.
Would you rather go with the National Association of Realtors’ figures? Okay then. They show the median price of an existing home down 6% from a year ago in December. That’s the sharpest drop yet for the cycle. New homes? Prices fell 10.9%, the sharpest decline in any month since 1970.
* What about the impact on banks and other financial firms from the Fed's largesse? These cuts will help firms pick up some extra interest income. That’s courtesy of the steeper yield curve (a fancy way of saying long-term interest rates are higher than short-term rates).
But here's the problem as I see it: Unlike in past financial crises (like the S&L debacle or the Long-Term Capital Management meltdown), it's not just largely one category of loan or isolated hedge fund problem that's hurting the industry. It's a little bit of everything.
To whit: We have plenty of well-documented trouble in first-lien residential mortgages, subprime or otherwise. But we also have problems with second lien home equity loans and auto loans, as this post discusses. And the credit card news isn't so great, either.
Then there’s the whole issue of balance sheet and asset quality. In plain English, the value of many of the complex debt securities that banks are holding on their books is slumping fast.
Standard & Poor’s just put out a report suggesting losses from subprime-related mortgage securities could top $265 billion – with a “B” – at regional banks, credit unions and other financial firms. S&P also either cut ratings or put its ratings on review for a whopping $534 billion worth of mortgage bonds and so-called collateralized debt obligations (CDOs). How much is $534 billion? It’s roughly half of ALL the subprime bonds S&P rated in 2006 and early 2007!
==> At the same time, the bond insurance debacle is getting worse. MBIA, the world’s biggest bond insurer, said it lost $2.3 billion in the fourth quarter. That’s a gigantic $18.61 per share – the biggest-ever quarterly hit. A key reason: It took $3.4 billion in losses related to markdowns on residential and commercial mortgages, and CDOs.
Fitch Ratings is already starting to downgrade the bond insurers. It cut Financial Guaranty Insurance Co., or FGIC, to AA from AAA, and it recently cut its rating on another company, Ambac Financial, to AA from AAA. The larger credit ratings agencies S&P and Moody’s could be the next to cut. And that could result in billions MORE in write downs for financial firms.
How much? Oppenheimer & Co. said bond insurer downgrades could force banks to take $70 billion in fresh writedowns. And Barclays Capital said banks could be forced to go hat in hand – again – to investors in order to raise ANOTHER $143 billion in capital to shore up their balance sheets.
==> As if that weren’t enough, many banks and brokers are also stuck holding tens of billions of dollars of leveraged loans – financing used to fuel the recent corporate takeover boom. Those loans are also losing value.
Bloomberg recently reported that banks are stuck with a $230 billion pile of high-yield, high-risk debt. That includes $160 billion of leveraged loans and $70 billion of junk bonds. Meanwhile, a basket of loans that S&P monitors recently traded down to about 91 cents on the dollar. If this continues, we’re going to see yet ANOTHER batch of write-downs among the major banks and brokers.
The bottom line: We still have a real battle going on -- between regulators and monetary policymakers, who are trying to fix the credit problems by cutting rates and forwarding bailout plans ... and the housing and financial markets, which are experiencing real problems and driving losses up throughout the financial industry.