Federal Reserve & Interest Rates

According to a former regional Federal Reserve President, the government sponsored mortgage agencies Fannie Mae and Freddie Mac are practically insolvent based on their current financial situation.  It appears that it will grow increasingly difficult for the two companies to raise additional capital in the near future.

The company’s credit-default swaps show traders are treating the AAA rated debt as if it were five steps lower.

Chances are increasing that the U.S. may need to bail out Fannie Mae and the smaller Freddie Mac, former St. Louis Federal Reserve President William Poole said in an interview. Freddie Mac owed $5.2 billion more than its assets were worth in the first quarter, making it insolvent under fair value accounting rules, he said.

The situation will probably grow worse for them in the short term as delinquencies and foreclosures have continued to climb in recent months as home prices keep falling.  For any sort of recovery of the housing market to happen these two agencies will need to take a large part.

Mortgage rates have also started to creep up again and coupled with tighter lending standards from banks, demand remains constricted despite the number of relative bargains out there with the surplus inventory of homes.  How much lower prices will fall remains to be seen but it is doubtful that economic growth will rebound until the housing market finally hits it’s bottom.

If they have to, the government will bail these agencies out as they fall under the category of “too big” to fail.  With the two companies having a hand in about half of the $12 trillion mortgage market, a failure would cause financial chaos to ensue that would make the previous subprime collapse seem like a walk in the park.   

The Dow Jones has reached bear market status and the S&P 500 is a percentage point away but a number of forecasting firms are predicting a turnaround for the market in the second half of the year.

The S&P 500 will rise 18 percent by January, according to the consensus projection of 10 U.S. strategists surveyed by Bloomberg.  The forecasts are based partly on estimates that profits will jump 50 percent in the fourth quarter after falling for the past year.

These are the same people that said that the worst of the credit crunch was over back in March so I have my doubts about a market recovery anytime soon.  Investors are still wary about the economic outlook and it is still quite possible for the economy to enter a recession although it has been quite resilient up to this point considering what has happened over the past year.

The problem is that the financial sector will continue to be weak as long as the housing prices keep falling.  Firms have already raised hundreds of billions in additional capital to shore up balance sheets to cope with writedowns from the subprime collapse and accounting changes may require them to raise even more.

While there are definitely some bargains out there with historical price to earnings ratios relatively low, it is doubtful the market can sustain a rally in the current economic climate.  Our economic troubles are also slowly spreading to the rest of the world and it seems that the rest of the world’s central banks are more committed to fighting inflation than the Fed is which will have a negative impact on their economic growth rates.

While it is likely that a global recovery will begin in this country since this is where all the trouble started, there haven’t been any signs that this will happen anytime soon.  The economy has been shedding jobs for the last six months and consumer spending is expected to fall once the economic stimulus payments run out.

There have been many critics to the Fed’s recent monetary policy decisions.  Some have cited that their actions in attempting to avoid a recession will only prolong the current stagnant economic growth pattern while increasing inflationary pressures which could have an even more detrimental effect in the long term.

At this point it might not be the worst thing in the world if the Fed decided to raise interest rates.  Right now a lot of investor money is being funneled into commodities markets but if the Fed bursts that bubble, you could see some of that money pouring back into the stock market and into the above mentioned bargains.

In a speech today, Treasury Secretary Henry Paulson called for new regulations to help liquidate failing firms without it affecting overall market stability.

“For market discipline to constrain risk effectively, financial institutions must be allowed to fail,” Paulson said in excerpts of a speech he will deliver in London.

“It is clear that some institutions, if they fail, can have a systemic impact, so we must give regulators the authorities to limit that impact and facilitate an orderly failure,” Paulson said.

Why are these regulatory changes needed?  Well back in March, the Fed intervened when it looked like Bear Stearns was in danger of failing, financing a buyout from JP Morgan and putting to risk potentially $30 billion in taxpayer dollars.

Through it’s excessive risk taking in the residential mortgage market, Bear Stearns deserved to fail but it couldn’t be allowed to due to the impact it would have on other financial firms.  Financial firms are tightly interconnected these days through counterparty risk in the credit derivatives market, a largely unregulated market that has had explosive growth in the past decade. 

It is a massively leveraged market that has the potential of causing financial Armageddon according to some well known industry leaders.  Although firms are slowly de-leveraging, there will still be the potential of a failure cascade as the credit crisis is far from over. 

Over the past few weeks speculation has run wild on Wall Street that Lehman Brothers would meet the same fate as Bear Stearns and need to be sold at a discount, although those rumors have abated somewhat recently.  While this is one potential trigger that has been avoided, the danger will likely exist as long as home prices keep falling and firms face the prospect of more writedowns.