In our Schaeffer's Media Outtakes series, Bernie Schaeffer dissects the news, using contrarian analysis to provide a unique take on the market.

"With the risk of US mortgage defaults now dispersed globally, not just Americans but everyone else in the developed world has an interest in averting an escalation in US defaults ... Tighter credit conditions make it harder to obtain a mortgage, and hence reduce the demand for housing. But the recent popularity of variable loans, known in the US as adjustable-rate mortgages (ARMs), could also increase the borrowing costs for those who already hold a house. That could raise defaults still higher while pushing house prices down tightening the credit crunch and deepening the impact on the economy. The loss of confidence in mortgage-backed bonds means that the increase in ARMs could be substantial maybe as much as 2.5 percentage points. For borrowers who were stretched in the first place, and who only borrowed on the basis of generously low initial "teaser" rates, that could be critical. Anthony Sanders, an economist at Arizona State University, suggests that a total of $500bn in variable mortgages is due to 'reset' this year, with another $450bn next year ... Worse, the last two chairmen of the Federal Reserve actively cheered on the irrational exuberance in US housing. Alan Greenspan, who stood down last year, gave ARMs a warm endorsement, and said that fixed-rate mortgages 'effectively charge homeowners high fees for protection against rising interest rates and for the right to refinance.' Those fees now look as though they would have been worth paying. As for his successor Ben Bernanke, in 2005 he said that the US had 'never had a decline in housing prices on a nationwide basis,' and that rising house prices 'largely reflect strong economic fundamentals,' not a bubble."
----(Financial Times "Lay the blame on Wall Street and Main Street" 8/31/07)

Schaeffer's addendum: The standard "blame the Fed" argument is that rates were kept too low for too long, which encouraged reckless borrowing and lending. But few mention the 17 rate hikes that ensued, and the fact that it is these rate hikes that are threatening to squeeze (if not evict) millions of homeowners over the next few years due to ARM resets.

Were all these rate hikes necessary? Forget even about current credit-market conditions that are now screaming for a rate cut. The yield curve had inverted long before the current crisis, and an inverted yield curve (where benchmark short-term rates exceed benchmark long-term rates) has traditionally been a precursor to a recession and a clear indication that Fed policy is too tight. And for a truly eloquent explanation of why current Fed policy is too tight, see my excerpt from Wayne Angell's recent Wall Street Journal op-ed piece.

So it can be argued that the Fed played "bait and switch" with the nation's homeowners, moving from an unnecessarily loose to an unnecessarily tight monetary policy even as the mortgage debt was being piled higher and higher. And now per the above piece, almost a trillion dollars in ARMs will become significantly more expensive over the next two years.

Ben Bernanke bought the bogus deflation scare in 2001 hook, line and sinker. And now when deflation is actually a threat through house-price implosion and ARM resets he worries about inflation. If he proves to be equally wrong about the economic backdrop this time, the consequences will be disastrous.

A 50 basis-point rate cut is needed, preferably before the next Fed meeting on September 18th. It is needed not for the purpose of bailing out profligacy on Main Street and on Wall Street, but to correct the consequences of the Federal Reserve's excessive rate hikes. And I can come as close to guaranteeing as I possibly can when speaking of the markets that if September 18th comes and goes with no such cut, the markets will not long thereafter force it out of the cold, dead hands of the current Fed Chairman.

Copyright Schaeffer's Investment Research http://www.schaeffersresearch.com

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