Sunday, August 19, 2007

US Mortgage Market

The current volatility in the World's equity markets is making a lot of folks nervous in the U.S. Most pundits believe that the Fed should ease rates because the main problem facing the economy is lack of liquidity, and that the crisis is due to the difficulty of hedging liquidity risk.

I am a bit more pessimistic. I tend to subscribe to the school of thought that what we really have is a looming insolvency problem. I have been talking to mortgage quants and the report I consistently get is that we are about see a wave of mortgage rate resets in the last quarter of 2007, with the peak hitting in Q1-2008. These resets will lead to a lot of foreclosures as a record number of people will be unable to pay their readjusted monthly mortgage. The people who know mortgage data well have insolvency on their minds -- and they are paid to look at mortgage data very closely.

Sure we have a liquidity problem, but I think that the credit rating agencies fell asleep at the wheel, and that led to too many easy loans. A quick examination of historical mortgage rates shows that we aren't exactly in a high interest rate environment:

Note that the Fed's cutting of the discount rates has already resulted in drops at the end of above charts. More importantly, the spread between conventional 30 Year Fixed mortgages, and 1 Year ARM's is still quite narrow.

So while I agree that we are facing a mini liquidity crisis, it is a reaction to the loose credit standards that were in place in the previous 2-3 years. I am a huge fan of Bill Gross, but I think prudent investors do know how to hedge liquidity risks.

If you are a Green Industry entrepreneur, be prepared to face a weakened economy over the next several months. My overseas friends be warned: this is not going to be confined to the US. Corporate credit markets are feeling the heat, currency carry trades are being unwound, ...

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