In the wake of a global euphoria surrounding the election of Barrack Obama as the next president of the United States, the economic horizon continues to darken and the markets continue to act with little logic. The Wall Street Journal reported that the legendary financial analyst Benjamin Graham first wrote about the stock market in 1949 to describe the way investors, acting collectively, often seem to resemble a person with bipolar disorder. In the manic phase, Graham wrote, investor's enthusiasm puts "a ridiculously high price" on stocks. When the market becomes depressed, investor's "fears run away them," and they are so eager to sell stocks that their behavior is "a little short of silly." We are in the depressed phase of the market with irrational buying and selling of stocks in light of economic statistics being released, and by interest seeking investors accepting negative real returns on their bond investments.

One measure that is being used to summarize the strain in financial markets is the TED spread. This is calculated as the gap between 3-month LIBOR (an average of interest rates offered in the London interbank market for 3-month dollar-denominated loans) and the 3-month Treasury bill rate. The size of this gap presumably reflects some sort of risk or liquidity premium.

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The age of free money may be at hand. As major central banks slash interest rates with unexpected speed, benchmark borrowing costs are now below core inflation for the first time since the early 1980s, and policy makers are signaling they will go deeper. Monetary policy is being eased because the 15-month credit crisis is inflicting harsher blows to growth and inflation than central bankers anticipated just two months ago. Yesterday the International Monetary Fund cut its month-old forecast for next year's global expansion to 2.2 percent from 3 percent, and predicted the first contraction in advanced economies since it was created in 1945. It estimated prices would rise just 1.4 percent in rich nations, less than half of this year's pace. The London interbank offered rate for three-month loans fell to 2.29 percent today from 4.82 percent on Oct. 10. The record drop still leaves Libor 129 basis points above the Fed's benchmark, compared with an average of 22 basis points in the five years before the global credit crisis began in August 2007. Rapid rate cuts are intended to avoid the fate of Japan, which endured a decade-long slump after its asset bubble burst in 1990 in part because its central bank was ``initially too timid and too slow to react,'' economists at Deutsche Bank AG said in a report yesterday. Central banks are betting that negative real interest rates will induce people to spend rather than save money that is declining in value, economists said. The strategy also aims to jolt investors and banks into seeking higher yields by making riskier long-term loans. Copyright © 2008 Mortgage-X.com Source: www.mortgage-x.com Reprinted with permission

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Banks' troubles have made it harder for many home buyers to get mortgages, and those who do qualify have to pay more. A borrower with good credit and a 20% down payment recently got charged an interest rate of 6.7%, on average, according to HSH Associates. It's true that this rate is not historically high (rates often surpassed 9% in the early 1990s). But it's more than the 6.2% that the same borrower would have paid at the beginning of 2008. The fact that mortgage rates have remained stubbornly elevated despite the government takeover of Fannie Mae and Freddie Mac leads some experts to believe that those rates are not headed down anytime soon. Then look at the fact that 18.6 million homes in this country are now sitting vacant, more than at any other time since the Census Bureau began tracking that figure in the 1960s. And that 2.8% of U.S. mortgage loans are now at least three months in arrears, up from 1.4% a year ago. That rate is projected to peak in early 2009. But if a recession lasts for three-quarters of the year, as some economists are predicting, the number of foreclosures could remain high longer. Add it all up and you have another lousy year for real estate. Home prices are down 20% nationwide since their peak in July 2006, according to the S&P/Case-Shiller home price index. Economist Nouriel Roubini of New York University, who accurately predicted the housing slide and credit crisis, expects another 20% decline in home prices next year. Patrick Newport of economic forecasting firm Global Insight projects a 15% drop. "We don't see the market turning until late 2009," says Newport.If they go so low that investors can start renting out homes for enough to cover their mortgage payments, we could see a wave of people snapping up bargain houses in 2009 - which could push prices higher by the time the next 12 months draw to a close.In 2010, real estate should be stronger, with fewer homes clogging the market.

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Sometimes, the market can move in mysterious ways. This week, stocks started with a 300-point gain, promptly dropped 1,000 points, and then, on Friday, gained back 248 points despite terrible employment numbers and news that General Motors, a titan of American industry for decades, may not have enough cash to make it through the end of the year. All of this poses a question: Huh? “The lesson people have to learn is they can no longer look for rational reasons for why short-term moves are happening,” said Randy Cass of First Coverage, a research firm. “At any given day on any given moment in time, you can step aside and see a 10 percent rally happen. You just have to stop trying to rationalize why,” he said. “People are waking up and they’re feeling one way on a Friday and another way on a Thursday, and that’s what’s driving this market right now.” This may come as cold comfort to those who cling to the belief that the stock market — that universal thermometer of the nation’s economy — offers clues to where the world of finance is heading. Ideally, investors place bets based on how they expect businesses to perform over time.

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The global economy is in recession. Will this lead to depression? And if not, how long and deep will the recession be? The answers to both questions depend on the extent of deleveraging by financial institutions. The amount of risk-free or "tier-one" capital a bank is holding is a good reverse indicator of how leveraged it is. Globally, financial institutions had about $5 trillion of tier-one capital on the eve of the credit crisis. Those in the United States and European Union had about $3.3 trillion of tier-one capital supporting a loan book of some $43 trillion. Then came the crisis. How much did they lose? There are three answers. If mark-to-market rules are applied, global financial sector losses are estimated to amount to 85% of tier-one capital. But mark-to-market rules are extreme and assume the banks are insolvent and that all their assets will have to be fire-sold for whatever they can fetch in today's dysfunctional markets. If economic value, a concept based on the present value of future cash flows of the assets, is used instead, current losses are about half the amount calculated using mark-to-market rules. All the bank losses have been offset by capital raisings of $420 billion from private sources and the promise of state capital injections of about $250 billion. The leverage of the U.S. and EU financial systems was 13 times tier-one capital before the crisis broke. Using mark-to-market rules, it is now more than double that. But using economic value or declared losses reveals that leverage is now back to what it was before the crisis began, thanks to capital raisings and the (assumed) full injection of promised state capital. Why then is all not well and credit growth ready to resume? There are three reasons. The first is that financial-sector leverage was too high before the credit crisis began. Second, the world economy has become accustomed to using $4 to $5 of credit for every $1 of GDP growth. Even if this profligate use of capital is halved, it still means credit expansion of 10%-15% is needed to achieve real GDP growth of 2%-3%. The recapitalization of financial institutions so far is only enough to maintain existing credit assets, but not expand them; ergo the credit crisis continues. Third, the current bank-asset losses do not include any allowance for future losses which will result from global recession. It seems likely that leverage, and therefore credit, of the financial system will shrink, even with state capital injections of two to three times what we have already seen. The bottom line is that, assuming further credit losses from global recession take U.S. and EU tier-one bank capital back to where it was before state injections and capital raisings, then financial-sector credit would have to shrink 37% just to keep leverage constant at precrisis levels -- that's how you get global depression. But government is now part of bank management. Government intervention could manage to limit the credit decline to less than 10%, at the cost of more capital injections. This will avoid the global depression that many fear, but at the high long-term cost of a socialized financial system. And it still heralds a very long, gray, global recession as the world learns to use less capital to meet its needs.

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The European Central Bank extended its boldest-ever series of interest rate cuts by slashing official borrowing costs by another half percentage point on Thursday. But it made clear that private banks had to help boost confidence in the face of the sharp economic downturn. The latest move came less than a month after the co-ordinated cut in global interest rates on October 8, when the ECB cut eurozone borrowing costs from 4.25 per cent to 3.75 per cent. But the size of the latest reduction disappointed financial markets, especially after the Bank of England slashed its main policy rate by 150 basis points, a move that appeared to have taken the ECB by surprise. © 2008 by Prof. Werner Antweiler, University of British Columbia, Vancouver BC, Canada. Permission is granted to reproduce the image below provided that the source and copyright are acknowledged. Time period shown in diagram: 9/Aug/2008 - 7/Nov/2008

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FROM THE ECONOMIST:

 

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