As the American economy appears to be on the precipice of a recession, the industry is now engaged in a dual debate about how to stave off a market downturn and how to recover from one.
All eyes are turned to Federal Reserve Chairman Ben Bernanke, who already faces his biggest challenge a little less than a year into his tenure. The Fed is scheduled to meet on Jan. 29-30, at which point it is expected to cut interest rates by 50 basis points or even more.
The Fed has cut the overnight rate by a full percentage point since September. However, its decision to cut benchmark U.S. interest rates by only 25 basis points in December drew the ire of some market participants who did not think Bernanke was acting aggressively enough. The strategy, however, is now changing, as there has been talk that the Fed could cut rates as much as 75 basis points this month.
On Jan. 17 Bernanke told Congress that he supported a quick stimulus package to boost the economy, which could include a combination of spending measures and tax cuts. President Bush has also thrown his support behind a stimulus package.
Those who thought the Fed acted too timidly in its response to the worsening credit conditions now see this as the time for Bernanke to become more hawkish in his adjustments. "Clearly [the Fed] kind of didn't get the joke," said Max Bublitz, chief strategist for SCM Advisors, an investment management firm based in San Francisco.
Bublitz believes the Fed made a policy mistake with its lower-than-expected 25-point rate cut in December and noted Federal Reserve board member Fredrick Mishkin's recent assertion that more rapid adjustments could be forthcoming. "We've had 100 basis points (cut) in three Fed meetings and he's suggesting we do more," Bublitz said. "I don't think 50 and 50 is out of the question. Frankly, the Fed knows how to deal with potential inflation better than it does potential deflation, which is a risk right now."
The threat of a recession loomed even closer last week when Citigroup, the largest U.S. bank, announced a massive $9.83 billion fourth-quarter loss. Furthering the downward spiral, JPMorgan Chase & Co. lost $1.3 billion and Merrill Lynch announced that it lost close to $10 billion in 4Q07 after a $14.6 billion write-down of bad investments.
If that weren't bad enough, retail sales deteriorated for the first time since 2002. It's not surprising then that Bernanke sounded a sober tone in a speech he gave on Jan. 10 about the broad toll the subprime meltdown has taken on the economy, which he said was worsening.
"Financial conditions continue to pose a downside risk to the outlook for growth," Bernanke said. "Market participants still express considerable uncertainty about the appropriate valuation of complex financial assets and about the extent of additional losses that may be disclosed in the future."
He added that despite small improvements in some areas, "the financial situation remains fragile, and many funding markets remain impaired." Bernanke also acknowledged that management of the short-term interest rate remains the Fed's best tool for promoting its main objectives of maximum sustainable employment and price stability.
The signals remain mixed about how close the U.S. economy is to a recession, or if it will even reach that point this year. Goldman Sachs, one of the only investment banks to escape the credit crisis virtually unscathed, predicted a recession this year in a research note it issued on Jan. 9, and even suggested that it is already upon us.
Donald Ratajczak, a consulting economist for Morgan Keegan, stated in a Jan. 14 market commentary that we will not know for at least several months. At that point, he wrote, it will be clear whether the depth of the decline and dispersion of the housing slump has led to economic despair and thus a recession.
Securitization's Cyclical Too
Mark Adelson, a principal at Adelson and Jacob Consulting, does not share the same certainty as Goldman Sachs. While conditions are muddled right now, he noted that unemployment is still not high, interest rates are fairly low and while the GNP is not growing, it is also not contracting.
"Could things turn to the worst?" Adelson asked. "Yes. It could get quite bad. I think that's a possibility, but it's by no means a sure thing."
Rather than debate whether or not the U.S. is already in a recession - a question best left to an economist, Adelson noted - he stressed the importance of policymakers preventing a similar market catastrophe in the future.
"If they can't do anything about the loans that are already out there, they can certainly do something about organizing the way America does business, about the way America buys homes so as not to have it happen again," he said.
SCM's Bublitz said policymakers should contain the psychological impact of recession talk before the economy dips to that point.
"Businesses see the same data that consumers do and they respond as well, and if we actually do start getting into this self-reinforcing cycle we could see ourselves with a couple of quarters of negative GDP and greater than 5.5% unemployment," he said. "I think that's what policymakers, both monetary and fiscal, have to get in front of now. Not dealing so much with raw data and raw definitions of all of this, but more the psychological impact of all of this."
The unraveling of the MBS market has drawn plenty of finger pointing, but market participants seem to agree by now that the securitization industry as a whole lost its way during the housing boom. The model, Adelson said, is going to change somewhat.
He quoted a published report that stated employment in the mortgage lending industry has already shrunk by over 100,000 jobs. "It's a cyclical business, and securitization is going to grow up realizing it's part of a cyclical business," he said.
Adleson said one of the lessons of the meltdown is that math should be aided by experience and instinct, and the other lesson is the need for greater understanding of credit risk and how it can spread. "Everyone who thought they were passing the risk along participated in blowing up their own market," he said. "Half of them are laid off and the other half are waiting to get laid off. They loused up their own market and now they have nothing to do because their market has gone away."
But before looking too far into the future, the industry still remains largely focused on preventing the worst right now. Much of the attention remains squarely on Bernanke and the Fed, but Congress too is mulling reform bills that could provide some relief to the housing market.
Jerry Howard, CEO of the National Association of Home Builders, is urging the Senate to follow the House's lead and pass a bill that would raise the conforming loan limits for Freddie Mac and Fannie Mae. This is seen as a way to boost liquidity and help spark the housing market.
Howard said that raising the GSEs' conforming loan limits is more important than the proposed lift on their portfolio caps in order to help markets like California and Arizona that became overheated during the housing boom.
"From our perspective that's why the GSEs exist," he said. "If they're not going to be out there and playing their role and providing liquidity in a time when the traditional banking sector is not as engaged in housing, then the GSEs are missing the very point of their existence."
The NAHB is also calling on Congress to pass a reform bill that would allow the Federal Housing Administration to revitalize its single-family mortgage insurance programs and expand the number of borrowers it can assist. This would put the FHA in the "unique position to help in this subprime crisis," according to Howard.
"Over the course of the last eight, 10 or 12 years, the FHA's role in the marketplace has been severely diminished," he said. "This bill would put it right back where it needs to be at the exact time when it needs to be there."
Adelson agrees that the GSEs will play a bigger role during a market recovery, calling them "the giant 800-pound gorillas of securitization." They are especially important to securitization because of their responsibility for putting American families in homes, he said.
Adelson argued that securitization should be practiced in the mode of the GSEs and mainstream product areas, much like it was before 2005.
"If you go back to the way things were in 2004, then it's not the end of the world, just like home prices going back to where they were in 2004 is not the end of the world," he said. "If home prices go back to where they were in 1994, then it would hurt. But if it means giving back some of the bubble, I'm just not going to get so worked up about that."
SCM's Bublitz noted that investors are as bearish about the stock market as they have been in years, but the growing consensus that a recession is upon us means the Fed and Congress are both acting more quickly to pump money back into the markets and participants can begin to slowly move forward.
"We're in the process of creating value in a number of areas," he said. "It's never fun to watch the markets get whacked to the extent that they are, but you're seeing a lot of the old sentiment get washed out, and I think ultimately that is the first step in creating opportunity."
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