Michael Gracie

Inflation is a nasty bug:

To reiterate, the last time Producer prices were this high, the Fed had rates up in the double digits — not at 2%…

Here’s a chart of the prime lending rate (as published by the WSJ) during “modern economic times” (each color change represents a rate change - click for larger view)…

I’ll bet few running around today remember how ugly things were in the midsts of that mountain-in-the-middle. But Paul Volcker was scrambling (and let’s note that he has been more vocal as of late too).

Producer prices have been rising for a while, but they held off passing on costs to consumers. That game is over. So, the highly leveraged are getting killed by plummeting home prices and the savers are getting killed by just about everything else.

And you can thank your Federal Reserve for that.

The open question is why?

The consistent sound bite seems to be “the housing boom that began in 2001…as a result of subprime mortgages”. Even today, Paul Krugman gives cover to Fannie Mae and Freddie Mac while trying to pin the problem on sub-prime post-millenia. It’s hogwash. As the chart below shows, the boom really began in 1995 (click chart for larger view):

I initially graphed homeownership against the S&P 500 for shits and giggles, but it does depict how liquidity rolls. What happened in 1995 to set off the explosion?

The 30-year fixed mortgage rate dropped significantly during the early ’90s, but was accompanied by little corresponding uptick in homeownship. Rates rose just over one percentage point in 1994, but soon corrected themselves.

Yet beginning in 1995 homeownership skyrocketed. Earnings followed, and so did stocks. The 2001 recession, triggered by the internet stock plunge and exacerbated by the the 9/11 terrorist attacks, took a swipe at the S&P. The Fed began hammering short-term rates to save people’s IRA accounts, and the byproduct was a continued run-up in housing on the back of more exotic mortgages combined with increasingly lackadaisical lending standards.

The juggernaut was long since in motion. But why?

UPDATE: I dug this up, which seems to claim affirmative action was partially to blame. While the Federal Housing Enterprises Financial Safety and Soundness Act of 1992 did provide for certain low-income mandates and give additional oversight powers over the GSEs to HUD, it seems the actual amount of loans purchased by the GSEs nary broke 1% of their total in any given year since. So while the GSEs touch almost half the overall mortgage market, it’s difficult to see how affirmative action could have gotten such a big ball rolling.

Headlines are sometimes veiled in sarcasm.

In the world according to this Bloomberg columnist, the Fed might start raising rates again really soon.

Sure they will.

In other news sure to make you feel warm and fuzzy, pharma company Bristol-Myers Squibb discloses they’re taking a hit from investments in sub-prime mortgages. And bond insurance big boy MBIA says it’s keeping its triple-A rating. S&P has other ideas.

UPDATE: I noticed the same Bloomberg columnist was recently tooting the horn of banking stocks. Of course, anything can look profitable when the SEC endorses your smoke and mirrors approach to loss disclosure.

Preliminary conclusion…the fed won’t be raising rates by summer’s end, and I wouldn’t own a banking stock if someone paid me to hold it Japan-style.

UPDATE 2: At least the analysts are getting a clue about those bank stocks.

Sticking to hard data, this morning’s Fed Funds rate cut of 75 basis points was the deepest on record. Who’s record? The Feds own record, dating back to 1971.

Note that there are several occasions where the Fed raised rates (either the discount or fed funds) by 3/4 of one percent: the summer of ‘73, September of 1980, and November of ‘94. But they never lowered it so significantly in one kick.

The Dow recovered roughly 2/3rds of its opening losses, ending the day down 128.11. I can’t remember such a harsh reaction on the part of equities to a rate CUT. It was hardly graceful.

The Economist calls the latest move desperation. With only a week to go until the next meeting, a 75 bip cut might make an investor think the Fed knows plenty they don’t.

UPDATE: It’s funny that oil for March delivery had punched 7-week lows when the Fed made the announcement - I’m not sure how long that will last now. You’d almost think the Fed wants $5 a gallon gas.

Dow futures were off 500. The Federal Reserve Bank decided this was unacceptable, and cut rates 75 basis points.

Barry Ritholtz’s crew calls the Fed the “Plunge Protection Team.” There is little doubt now that the “PPT” surely exists.

My call for the next asset bubble? Bread. Buy now.

As an aside, Donald Luskin of Smart Money proves some financial journalists don’t have anything intelligent to say. To propose that “bears” caused a panic that made individual investors run for cover is simply idiotic (h/t to Paul Kedrosky). “Bears” didn’t make anyone borrow money they couldn’t pay back (which is the primary cause of the present situation). Second, most individual investors likely have not gotten out yet - in fact they are probably still listening to folks like UBS.

UPDATE: The Fed move had not, as of 9:00 am, had it’s intended effect. S&P futures were trading down 60 and change versus fair value, essentially unchanged from from the 4.25% Fed Funds rate world. NASDAQ futures much the same - off roughly 84. Now we get $5 a loaf bread AND decimated equity markets. Maybe the Fed was taking cues from Larry Kudlow .

UPDATE 2: B of A is another recommending buying stocks during the panic. That of course comes after they just announced a 4th quarter hammering - net profit down 95%. This is reminiscent of the earlier part of the decade, when banks were making recommendations in the face of egregious fundamentals - and we all know how that one turned out…everyone lost their shirts, and then sued.

Here’s a tasty look at the notional value of the credit default swaps outstanding (*) for the last few years:

The notional value is essentially the par value of the underlying credit. We know there was a heck of a lot of credit being granted during the period, and it also seems that a lot of “insurance” was being written against its potential for default.

Around the same time bankers everywhere were looking over their shoulder if someone asked them how their debt portfolio was doing, everyone and their mother was scrambling for sanity in the rate markets (*):

Of course, there’s an awful lot of speculation buried in those numbers, as well as hedging previous hedges. How it all unwinds is anyone’s guess. Meanwhile, investors are “bracing for more bad bank news”. With banks bantering around numbers in the tens of billions, while exposure is floating around in the tens of trillions, I wonder what investors are actually “bracing” with.

Meanwhile, at least a few analysts are starting to speak out (and keep in mind that sub-prime is only a sliver of the total indebtedness floating around).

* Data taken from the International Swaps and Derivatives Association’s twice yearly dealer surveys.

UPDATE: Just a sliver.