vaughnwoods

George Herbert Walker Bush’s failed presidential reelection bid will forever be linked to a weak economy. His son appears to be leaving a similar legacy to the succeeding U.S. President. One of the main reasons for the repeat is the declining mortgage market, which President Bush has just addressed with his new initiative. If you thought you knew all about the many strategies underway to keep the subprime meltdown in America from becoming the next recession, this report will be an eye opener. Let’s begin with a brief background.

Recall that George Bush Sr. took office in 1989. By 1990 the American economy had plunged into recession. Contributing factors to the slump included rising oil prices following Iraq's invasion of Kuwait, a sharp increase in interest rates, and declining availability of credit. Output fell 1.6% and 1.7 million jobs were cut. Unemployment rose from 5.2% in 1989 to 7.5% in 1991. Federal Reserve Board Chairman Ben S. Bernanke does not plan to make the same mistake of supporting an environment of declining credit availability as the economy weakens. The Fed has been forthright in their strategy to stabilize the financial markets. Unfortunately while the Fed strategizes, so does Congress.

Democratic Congressmen Barney Frank along with Chairman of the House Committee on Financial Services and two other Democrats, have co-sponsored a bill that uses federal law to save you from your bank. Called the Mortgage Reform and Anti-Predatory Lending Act of 2007, the congressional bill promises to protect the public from bankers who lend money too freely. This legislation comes at a time when the world markets are tightening credit. Herbert Hoover made the mistake of tightening credit during a declining market and the result brought about the Great Depression. No President since has been so ill advised or hamstrung to make the same mistake.

According to the Wall Street Journal, in 2005 a similar law in Illinois resulted in a 45% fall in homes sales within neighborhoods affected by the Illinois Fairness in Lending Act. Congressional legislators may think they are protecting themselves politically by supporting anti-predatory lending practices, yet there is no definition for predatory lending practices, making anyone who cannot meet their mortgage payment a potential legal recruit. The legal cost is passed onto the consumer.

Millions of adjustable rate mortgages were sold on the basis that the low loan rate would reset to a higher fixed rate after some period of time, usually five years. After a loan resets, a borrower is faced with higher monthly mortgage payments and is at greater risk of default. The current default rate for subprime mortgages is approaching 18%. According to Credit Suisse Research, prior to President Bush’s new mortgage freeze initiative, two giant waves of resets were scheduled to occur between 2007 and 2012. Subprime mortgage resets were estimated to peak at around $35 billion in May 2008, while approximately $50 billion in Option ARMs and Unsecured ARMs were scheduled to reset in May 2011. Now expect this schedule to be pushed out further.

In the equities markets, current recession fears are based upon the notion that an expansion in the housing slump will alter consumer confidence, slow economic growth and expand unemployment. However, if (1) congress doesn’t legislate the end of borrowing as we know it, (2) if the Federal Reserve Board is allowed to continue to make political-neutral decisions and (3) if the low yielding bond market continues to remind investors that equities offer great value relative to low yielding bonds, the slow U.S. economy should not suffer significant additional slowing through the third quarter of 2008. If you’re an investor worried that much can happen between the end of 2007 and mid-2008, here is good news.

The good news for securities investors is that residential construction no longer accounts for a significant portion of U.S. Gross Domestic Product. In 2007 residential construction has only accounted for 4.5% of total nominal U.S. GDP. The remainder of this nation’s $13.927 trillion nominal GDP is attributed as follows: 70.3% in consumer spending, 10.7% in business investment and 19.5% in government spending. The totals do not add up to 100% because of the impact of net exports and inventories on GDP (Briefing.com 11-26-2007).

Therefore, It doesn’t appear that residential construction weakness will cause a recession in the US next year because global trading is strong, domestic government spending should grow at some 3% per annum, business spending should remain strong, and banking constraints should ease. Moreover, the strongest indicator of a healthy economy is employment and the jobs report remains strong. According to the December 5th issue of Calculated Risk, an online financial blog, the Bush/Paulson mortgage freeze plan will help borrowers who took out adjustable rate mortgages between January 2005 and July 2007 whose adjustable rate mortgages are set to reset between January 2008 and July 2010. Borrowers whose credit scores are below 660 out of a possible 850 and whose score has not risen since the loan was issued will be given priority for debt relief. Clearly the majority of borrowers holding adjustable rate mortgages will not qualify for the Presidents subprime mortgage freeze program. As the December 2nd issue of Times Online puts it, hundreds of thousands of borrowers are being warned they will be frozen out of new deals as the credit crisis worsens. Banks and mortgage brokers are asking for big deposits for the best loans and subjecting customers to more stringent income checks. Until now it had been assumed that a mortgage freeze would only be a problem for borrowers with bad credit records. However, brokers say standard borrowers are also struggling, especially people with larger loans. So the question now is, what further steps must be taken in the days and months ahead to help people remain home owners?

Unfortunate as it may be, as real estate opportunities remain poor, securities portfolios become stronger, to a point. As long as lower interest rates, strong free cash flows, and easier hurdle rates for new projects remain in place for corporations, the stock market should do well. It’s all about dodging the recession bullet and doing so in an election year.

Contact us to learn more about working with Vaughn Woods Financial Group.

Best Regards,

Vaughn L. Woods, CFP®, M.B.A.

*Investors should be aware that there are risks inherent in all investments, such as fluctuations in investment principal. Past performance is not a guarantee of future results. Asset allocation cannot assure a profit nor protect against loss. Although the information has been gathered from sources believed to be reliable, it cannot be guaranteed. Views expressed in this newsletter may not reflect the views off Delta Equity Services Corp. The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice.

**Credit Suisse, Market Edge