Smith Faculty Opinion Article

October 18, 2007

By Dr. Peter Morici, Professor of International Business
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 Peter Morici

Why Bernanke Should Cut Rates

This week Federal Reserve Chairman Ben Bernanke and Treasury Secretary Henry Paulson admitted the mortgage crisis and housing slump are more critical than previously assessed. Paulson is prodding major players in the private capital markets to create a safety net for bonds that fund home mortgages and refinance more adjustable rate mortgages (ARMS). The goal is to put a floor under housing prices and save the economy from recession. An interest rate cut from the Federal Reserve would help a lot.

The Single-Master Liquidity Enhancement Conduit (SMLEC), established by Citigroup, JP Morgan and Bank of America, will purchase mortgage-backed bonds, known as collateralized debt obligations (CDOs). Through the Hope Now initiative, the Bush Administration is encouraging banks and mortgage companies to restructure ARMs whose rates will soon reset to unaffordable levels and thrust homeowners into foreclosure.

Understanding the Conduit

The idea behind the SMLEC is the mortgages behind CDOs have significant intrinsic value the bond market is not currently assigning to them.

Most mortgages behind CDOs will be repaid, either through refinancing or scheduled payments. While some will fail, those mortgages have residual value, because the homes will be resold, albeit at discounted prices. The intrinsic value of CDOs is the present value of loan repayments and the net proceeds from foreclosures.

Currently, the bond market cannot effectively value CDOs, because bond buyers cannot evaluate prospective default rates for the mortgages behind CDOs and sale prices of homes that go into foreclosure.

Default rates and resale values depend on one another. The fewer homes that default, the higher the resale value of those that do default. The higher the resale values of homes, the easier it will be for distressed homeowners to refinance and avoid default.

The Hope Initiative

The Hope Initiative is intended to encourage banks, mortgage companies and mortgage servicers to reach out to homeowners with ARMs, whose interest rates will soon reset to unaffordable levels.

Many of those homeowners should refinance to more affordable fixed-rate mortgages, but cannot refinance because the values of their homes have fallen or were not assessed properly in the first place.

Some homeowners cannot afford current interest rates on fixed-rate mortgages, given the higher rates bankers now demand from borrowers with less than perfect income and credit records.

Its either hang together or hang separately for the banks, mortgage companies and investors. They are being asked by the Bush Administration to exhibit flexibility in working with distressed homeowners.

It serves their interests to act in concert, because the liquidation of values of most mortgages they hold will be lower and their losses will be a lot larger if they dont act generously and together, throw most troubled homeowners into foreclosures, and send home prices into a death spiral. Too many defaults will glut an already weak resale market with too many houses.

Lower mortgage interest rates would help a lot. Many more distressed homeowners could afford make the payments on a 30-year mortgages, if mortgage rates came down by 25 or 50 basis points.

Ben Bernanke can lower federal funds rate again when the Federal Reserve interest rate setting committee next meets on October 29-30; however, pulling down short-term rates has only a limited effect on long-term mortgage terms. Supplemental initiatives should include raising the cap on Fannie Mae conforming loans to well above $417,000, and facilitating greater participation by the federal mortgage banks, generally, in the creation of CDOs.

The Federal Reserve could start buying 10- and 20-year Treasury securities to directly bring down long-term interest rates. That would most efficiently employ the flexibility of capital markets to contribute to a solution to the credit and housing crises.

Economic Forecasts

Week of October 22

October 25
Durable Goods - September 1.2% -4.9
Durable Goods Shipments 0.2 -1.6

Existing Homes Sales - Sept 5.100m 5.50m

Help Wanted Index - Sept 23 23

October 26
New Homes Sales - Sept 0.765m 0.795

Mich Cons Sentiment - Oct (r) 82.0 82.0

Week of October 29

October 30
Consumer Confidence - Oct 100 99.8

October 31
ADP Employment - Oct __ 58

GDP Q3 - Advance 3.0% 3.8
GDP Deflator _._ 2.6 PCE 3.4 1.4
PCE Deflator 1.5 4.3
Core Deflator 1.6 1.4
Corporate Profits _._ 6.1
After Tax _,_ 5.2

Employment Cost Index - Q2 0.9% 0.9

Construction Spending - Sept 0.0% 0.2
Chicago PMI - Oct 55 54.2

Federal Funds Target 4.50 4.75

November 1

Personal Income - Sept 0.5% 0.3
Per Con Expenditures 0.4 0.6
PCE Deflator 0.2 -0.1
Core PCE Deflator 0.2 0.1
Real Per Consumption 0.1 0.6

ISM Index - Oct 52.7 52.0 ISM Prices 61.0 59.0

Pending Homes Sales - Sept 85.5 85.5

November 2

Nonfarm Payrolls - Oct 100K 110
Manufacturing Payrolls -7 -18
Unemployment Rate 4.7 4.7
Average Work Week 33.8 33.8
Hourly Earnings 0.3 0.4

Factory Orders - Sept 1.1% -3.3
Durable Goods Orders 1.2 -4.9
Nondurable Goods Orders 1.0 -1.6

Peter Morici is a professor at the University of Maryland School of Business and former Chief Economist at the U.S. International Trade Commission.

Peter Morici is a professor at the University of Maryland School of Business and former Chief Economist at the U.S. International Trade Commission.