Read Between Bernanke's Lines: Things Are Going To Get Worse

There was a wild ride in the market on Thursday January 10th as the following chart shows.

$SPX S&P 500 10 Minute Chart



click on chart for sharper image

Fed To Slash Interest Rates

Around 12:00 Bernanke sent the market flying by Opening The Door For Steep Rate Cuts.

Federal Reserve Chairman Ben Bernanke, acknowledging the growing threat from fragile financial markets and weakening employment, opened the door to "substantive" cuts in interest rates.

The "outlook for real activity in 2008 has worsened and the downside risks to growth have become more pronounced," Mr. Bernanke said in a speech. "In light of recent changes in the outlook for and the risks to growth, additional policy easing may well be necessary."

He added, "We stand ready to take substantive additional action as needed to support growth and to provide adequate insurance against downside risks."

Bernanke's Speech

At the Women in Housing and Finance and Exchequer Club Joint Luncheon, Washington, D.C. Bernanke spoke on Financial Markets, the Economic Outlook, and Monetary Policy.

....Continued increases in the prices of energy and other commodities, together with high levels of resource utilization, kept the Committee on inflation alert.

But perhaps an even greater challenge was posed by a sharp and protracted correction in the U.S. housing market, which followed a multiyear boom in housing construction and house prices. Indicating the depth of the decline in housing, according to the most recent available data, housing starts and new home sales have both fallen by about 50 percent from their respective peaks.

My Comment: Perhaps?

In all likelihood, the housing contraction would have been considerably milder had it not been for adverse developments in the subprime mortgage market.

My Comment: In all likelihood the ocean would be less wet were it not for all the water.

Although poor underwriting and, in some cases, fraud and abusive practices contributed to the high rates of delinquency that we are now seeing in the subprime ARM market, the more fundamental reason for the sharp deterioration in credit quality was the flawed premise on which much subprime ARM lending was based: that house prices would continue to rise rapidly.

My Comment: The Fundamental reason for this problem is a Fed that kept interest rate policy too low too long.

Fortunately, after a number of years of strong earnings, most financial institutions entered the current episode in good financial condition.

My Comment: They are not in good financial shape anymore.

Recently, however, incoming information has suggested that the baseline outlook for real activity in 2008 has worsened and the downside risks to growth have become more pronounced. Notably, the demand for housing seems to have weakened further, in part reflecting the ongoing problems in mortgage markets. In addition, a number of factors, including higher oil prices, lower equity prices, and softening home values, seem likely to weigh on consumer spending as we move into 2008.

Financial conditions continue to pose a downside risk to the outlook for growth. Market participants still express considerable uncertainty about the appropriate valuation of complex financial assets and about the extent of additional losses that may be disclosed in the future. On the whole, despite improvements in some areas, the financial situation remains fragile, and many funding markets remain impaired. Adverse economic or financial news has the potential to increase financial strains and to lead to further constraints on the supply of credit to households and businesses.

A second consequential risk to the growth outlook concerns the performance of the labor market. Last week’s report on labor-market conditions in December was disappointing, as it showed an increase of 0.3 percentage point in the unemployment rate and a decline in private payroll employment. It would be a mistake to read too much into any one report. However, should the labor market deteriorate, the risks to consumer spending would rise.

My Comment: The risk is that consumer spending continues to rise in the face of unemployment that is nearly guaranteed to rise. Credit card defaults are going to be massive.

Monetary policy has responded proactively to evolving conditions. As you know, the Committee cut its target for the federal funds rate by 50 basis points at its September meeting and by 25 basis points each at the October and December meetings. In total, therefore, we have brought the funds rate down by a percentage point from its level just before financial strains emerged.

However, in light of recent changes in the outlook for and the risks to growth, additional policy easing may well be necessary. The Committee will, of course, be carefully evaluating incoming information bearing on the economic outlook. Based on that evaluation, and consistent with our dual mandate, we stand ready to take substantive additional action as needed to support growth and to provide adequate insurance against downside risks.

Things Are Going To Get Worse

Except for an obvious attempt to deflect blame from the Fed for its major contribution to this mess, this was a remarkably candid speech by Bernanke. I left out many significant portions, so you may wish to read the whole thing.

For the Fed to admit these problems is an obvious admission that things are going to get worse. It's risky to apply messages to any stock market action, but perhaps that is the message behind "the finger". Euphoria over bigger than expected rates cuts was short lived.

Bank of America to the Rescue

The New York Times is reporting Bank of America in Talks to Buy Countrywide.

The Countrywide Financial Corporation, the troubled lender that came to symbolize many of the excesses of the subprime mortgage crisis, is reportedly negotiating a sale to Bank of America, a move that would rescue Countrywide from an uncertain future.

As part of a potential deal, Mr. Mozilo could lead a transition team and maintain an executive title for an interim period, people briefed on the talks said. Bank of America and Countrywide both declined to comment.

The fall of Countrywide, and its possible sale to Bank of America, underscores the deep problems of financial institutions caused by the ripple effects of the housing bust, which threatens to throw the economy into a recession. Wall Street banks have suffered steep losses, and several chief executives have been forced out, as the mortgage crisis has widened.

Why Would Bank of America Buy Countrywide?

Inquiring minds are questioning the deal. Many people have emailed me all day wondering "Why now?" After all, "Why not wait until bankruptcy when previous deals give Bank of America first lien on assets?"

I am wondering if those are the right questions.

I asked a widely respected friend of mine this question: Could there have been encouragement, cajoling, dare say it begging by the Fed and/or treasury for Bank of America to bail out CFC to prevent a cascade of defaults?

Here was the reply: The smart money says yes. Have You read Confessions of an economic hit man?