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Five Things You Need to Know: Vindication!; How the Game Is Played; How the Game Is Played, Part II; Housing Affordability; The Fed's Really Makin' a Statement!


What you need to know (and what it means)!


Minyanville's daily Five Things You Need to Know to stay ahead of the pack on Wall Street:

1. Vindication!

The Federal Reserve's preferred measure of inflation fell below 2% for the first time in three years last month, "vindicating" the Federal Reserve Open Market Committee's decision to soften its description of inflation yesterday, the Wall Street Journal trumpeted.

  • The Fed's preferred measure of inflation, the Core Personal Consumption Expenditures Index rose 0.1% in May, and slipped to 1.9% year-over-year, the first reading below 2% since April 2004.
  • A lot of backslapping was heard in conjunction with the release, and hey, is that the smell of a victory cigar we're sniffing?
  • Yesterday the Fed left short-term interest rates unchanged at 5.25%, but did make some changes to the policy statement )more on that in today's Number Five.
  • Meanwhile, personal incomes and personal spending grew a bit less than expected in May.
  • Personal income rose a seasonally adjusted 0.4% compared to the month before, the Commerce Department reported.
  • Income decreased a revised 0.2% in April, more than the 0.1% decrease originally reported.
  • As well, personal spending rose less than expected, increasing 0.5%.
  • Noteworthy on the personal spending internals was a 0.1% increase on services, down from April's 0.8% increase.

2. How the Game Is Played

An important Bloomberg article this morning spills the beans on how the game is really played on Wall Street.

  • Standard & Poor's, Moody's Investors Service and Fitch Ratings are masking growing losses in the market for subprime mortgage bonds by not cutting the credit ratings on about $200 billion of securities backed by home loans, Bloomberg is reporting.
  • This is precisely the mark-to-model and conflict of interest issue Minyanville Professor John Succo first raised more than a month ago.
  • Bloomberg has found that almost 65% of th bonds in the indexes that track subprime mortgage debt don't meet the ratings criteria in place when they were sold.
  • So why aren't the ratings agencies downgrading the credit ratings?
  • Downgrades by S&P, Moody's and Fitch would force hundreds of investors to sell holdings, Bloomberg says.
  • Meanwhile, executives at S&P, Moody's and Fitch say they are waiting until foreclosure sales show that the collateral backing the bonds has declined enough to create losses before lowering ratings on some of the $6.65 trillion in outstanding mortgage-backed debt.
  • That certainly sounds reasonable... until one realizes that both S&P and Moody's maintained investment-grade ratings on Enron debt until days before the company filed for bankruptcy.
  • And this leads us to part two of How the Game Is Played...

3. How the Game Is Played, Part II

While the ratings agencies drag their feet on downgrades, even as defaults mount, mortgage companies are doing whatever they can to work out deals with borrowers to avoid foreclosures.

  • A story in the Wall Street Journal this morning takes a look at how lenders are scrambling to work out deals with borrowers to keep them from moving into foreclosure.
  • Why bend over backwards to help borrowers?
  • Simple: "Lenders usually end up losing money on foreclosed homes because of legal and other costs and the need to sell those properties fast, often at a knockdown price," the Journal notes.
  • But here's the catch. Efforts on the part of lenders to hold down foreclosures creates conflicts between the mortgage companies and investors in securities backed by home loans.
  • The fear among investors is that the modified loan agreements simply delays the inevitable... pushing foreclosure out another year or so, and as a result potential losses on their investments.

4. Housing Affordability

We know home prices are declining. Every report, whether it's earnings filings from the likes of Lennar (LEN) and KB Homes (KBH) or Existing Home Sales from the National Association of Realtors, tells us they are declining.

  • So why, then, is Housing Affordability declining too?
  • The National Association of Realtors reported that its composite Housing Affordability Index fell to its lowest level in five months in May, to 109.9 from April's 112.4.
  • How can affordability be declining even as prices decline?
  • For one thing mortgage rates are moving higher.
  • The report shows that the effective rate on loans closed on existing homes is at its highest level since February, 6.43%.
  • That may seem relatively low, but the mortgage payment as a percentage of income increased to its highest level since December.

5. The Fed's Really Makin' a Statement!

So the Fed left interest rates alone yesterday, but there were a number of "tweaks" to the policy statement.

  • Gone from the FOMC statement is the nod to "elevated" core inflation - and today's Core PCE somewhat vindicates that view.
  • However, lest anyone thinks the Bernanke-Fed is willing to submit to any arm-twisting, cajoling or external market pressures, there was absolutely no mention of either energy or food prices.
  • Of course the core reading has "moderated" - but it's the potential for "volatile" food and energy readings to become less "volatile" and more "secular" that has markets concerned.
  • Another noteworthy change was the shift from a "slow" economy in the first quarter to a "moderate" economy through the first half of the year.
  • Every time the FOMC meets and releases a statement we're among those pointing at the statement and wondering, "How can they say those things?"
  • Sure, it's an entertaining cocktail party exercise to be sure.
  • But what if the FOMC really stated what they believe may be happening in the economy?
  • Would we even want that? Doubtful.
  • After all, part and parcel with the Fed's self-mandated mandate is "managing inflation expectations" and controlling psychology to avoid "confusion" and "market turmoil."
  • No surprises!
  • So today, just for imagination's sake, we take a look at what a reality-based FOMC statement might look like.

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