Finance and Investments...what's behind the market volatility these days?

For those of you who don't already know, my educational background from college was in finance. While I work in IT, I'm still a hobbiest when it comes to finance and investments, and I still actively trade stocks and commodities. The piece I've written here was initially a web forum response I wrote, but I decided I'd share it here if for no other reason than to meet my goal of posting frequently and giving people more of a window into what I find interesting in life and what I spend my time doing.

The Fed cut the discount rate 50 basis points this morning (6.25 > 5.75). There's a possibility we may see a 25 basis point move in the federal funds rate in October if inflation doesn't move any further north of where it is now. Core CPI still moved .2% last month, which was higher than the forecasted .1%. We're still seeing inflation over 2% annualized so I highly doubt Bernanke will cut the federal funds rate as long as this is the case. Cutting the discount rate will help with liquidity in the short term with the credit crunch, cutting the federal funds rate won't really help with short term liquidity issues if inflation stays above 2%. Yes decreasing the fed funds rate will increase access to the money supply however if inflation rises then the two effectively cancel each other out.


The issue right now, IMHO, isn't about making money cheaper or more plentiful by and large (what the Fed can do in other words). The issue at a macro level is that the unfolding mortgage loan crisis has introduced loss of confidence across the board which has in turn produced a run on the credit markets (similar to the run on banks that have occurred in the past).


My wife and I were talking about this whole issue last night, because we're considering purchasing and building a new home soon, so we're trying to ascertain how best to move forward. Essentially, as I told her, even though the secondary mortgage markets, the RMBS markets (Resident Mortgage Backed Securities), and the CLO/CDO/derivatives markets have become amazingly complex over the last twenty years, so much so in fact that it has become extremely difficult to ascertain what the true value of these overly complex securities really are, in the final analysis, if we understand how banks and mortgage companies fund loans, via a combination of deposits, asset holdings, and lines of credit, etc., then at a high level, if any one of these pieces of the puzzle experiences a corporate or consumer confidence crisis for whatever reason, in this case uncertainty on the value of mortgage securities, then the corporations and consumers will start to pull back, or stop purchasing the securities in question, or attempt to recall their monies, or sell the securities, and those financial institutions providing access to credit, will tighten credit standards and/or suspend availability of credit altogether. The fact is that we have a major confidence crisis on our hands here on multiple levels, and we also most likely have a rather large real estate asset bubble that has peaked and is starting it's downturn.

The chart posted at the top of the page demonstrates what I'm writing about here today. Now, this particular chart is also predicting a pretty severe asset bubble collapse, which I don't necessarily agree with, but this chart also demonstrates something very important that none of us should overlook. We are in a real estate asset bubble. We've just seen the peak, the only question is, how far down will the adjustment be. Anyone who believes that the subprime "crisis" is over, is most likely sorely mistaken. The majority of ARM loans sold over the last several years don't reset until next year. The total amount of outstanding subprime and Alt-A ARM's that will reset in just the first few months of 2008 alone will add up to a larger amount than the entire year of ARM loans for 2007. In other words, we're just in the beginning of what I view as a mortgage loan crisis. We have the largest mortgage loan company in the U.S. on the brink of bankruptcy. I'll say that again, we have the largest mortgage loan company in the U.S. on the brink of bankruptcy. And Countrywide isn't overly exposed to subprime loans from a portfolio perspective, most of the companies that were overexposed, have already gone bankrupt starting late last year into the first quarter of this year.

When you start to realize that almost without exception the economic growth experienced since the 2001 recession was due to the housing and construction industries, that a significant portion of the job growth we saw was tied to these industries, and a significant portion of consumer's ability to spend was tied to MEW's (Mortgage Equity Withdrawals), and then you come to realize that all of these pieces of the puzzle are in a genuine slump, then it becomes much easier to see a recession on the horizon. Why? We'll start to see job growth numbers decrease (already did last month), unemployment numbers increase (already did last month), consumer spending decrease (starting to now), and so forth.

The real kicker this time around is, economically we've got a situation we've never had to deal with before (we always do in one way or another - that's why forecasting is never entirely accurate). In times past when asset bubbles burst, we had aggregate national savings, we had conversative banks making conversative loans that required 20% down on homes. In other words, consumers and financial institutions could absorb the short term burst of the asset bubble, because sufficient equity and savings existed to absorb price deflation. This time around, there's no savings and comparatively little equity. It's a brave new world in these respects. Nothing like the unknown to make things a little exciting!