In this issue:

Soaring Home-Mortgage Rates Threaten Consumer Bubble

End of Refinancing Boom Could Shatter 'Wealth Effect'

Greenspan Has Lost His Credibility

Rapid Interest-Rate Rise Could Trigger Huge Losses at Fannie Mae

Pension Funds Sue Freddie Mac Over Accounting Tricks

Mortgage Rate Hikes Threaten Housing Price Deflation and Foreclosures

Aviation Week Highlights Collapse of U.S. Machine-Tool Sector

Job-Cut Announcements Soared in July

Michigan Official Blasts Administration for Ignoring Manufacturing


From Volume 2, Issue Number 32 of Electronic Intelligence Weekly, Published Aug. 12, 2003

U.S. Economic/Financial News

Soaring Home-Mortage Rates Threaten Consumer Bubble

Surging mortgage rates could the pop consumer bubble, warned the New York Times in a front-page article on Aug. 5. Mortgage rates have soared as the bond market has collapsed—due partly to the Federal Reserve—causing mortgage refinancing to drop by half during the past several weeks. Were long-term interest rates to continue to rise, they would make it more expensive for Americans to buy a house or to borrow money against their houses (i.e., home-equity loans), thereby threatening consumer spending—the "pillar" of the U.S. economy, warns Edmund Andrews. Businesses would also face higher borrowing costs.

The jump in long-term interest rates shows that the Federal Reserve has lost its influence in the financial markets, Andrews notes. Investors ignored the Fed's lowering of the Federal funds rate, and instead pushed up long-term interest rates by selling Treasury bonds, due to doubts about the Fed's ability and willingness to take "unconventional" actions to flood the markets with money. "It looks to some people now as if the emperor has no clothes," stated Sung Won Sohn, chief economist at Wells Fargo, referring to Federal Reserve Chairman Alan Greenspan.

Mortgage lenders, to counter the risk of borrowers' repaying their loans early, hedge their $5 trillion loan portfolios by buying Treasury bonds. But as interest rates shot up in July, mortgage lenders expected a drop in refinancing activity, and sold Treasuries, or derivatives securities linked to them. This pushed interest rates higher, creating a vicious cycle.

End of Refinancing Boom Could Shatter 'Wealth Effect'

Rising mortgage rates could also trigger a reverse "wealth effect" among homeowners, the Wall Street Journal warned in its lead editorial Aug. 6. Climbing long-term interest rates could signal the end of the mortgage refinancing boom that has propped up consumer spending. Homeowners would no longer be able to raise cash either by cash-out "re-fi's" or through home-equity loans, while facing increasing mortgage payments. Housing prices would eventually fall if rates continue to rise.

Financial institutions—notably Fannie Mae and Freddie Mac—which have bet on low interest rates, would be hit by the rising rates and resulting mortgage defaults, through interest-rate derivatives and mortgage-backed securities. In order to "cope with, and minimize" hedge-fund and bank failures due to the "bond bath," the Journal suggests "beef[ing] up" the U.S. Treasury's financial team.

Greenspan Has Lost His Credibility

In a Wall Street Journal op-ed Aug. 8, headlined, "The End of Maestro-Economics, Hoover Institute fellow Melvyn Krauss declares that the financial markets no longer believe anything Fed Chairman Alan Greenspan says. Greenspan manipulated bond prices by using unconventional measures of monetary stimulation, and talking up a non-existent deflation problem, Krauss writes.

The Federal Reserve "should use next week's FOMC [Federal Open Market Committee] meeting to start a new era by foregoing manipulative hype," insists Krauss, and by "leveling with the American people about the true state of their economy—no rosy scenarios please." "The last thing we need at this stage is for the stock market to suffer the same fate as bonds."

Rapid Interest-Rate Rise Could Trigger Huge Losses at Fannie Mae

The giant home-mortgage lender Fannie Mae faces much larger losses—billion of dollars—from a rapid rise in interest rates, than it has admitted publicly, according to the New York Times Aug. 7. The story is based on the company's computer models, which were leaked to the Times by a former employee, who said he feared Fannie was becoming a risk, not only to taxpayers (the Federal government likely would repay the debt that Fannie had issued if the company could not), but also to the entire financial system.

At the end of 2002, the models showed Fannie's mortgage portfolio would have lost $7.5 billion—50% of its market value (assets minus debts), if interest rates rose abruptly by 1.5%. The mortgage-finance Goliath has never disclosed what its losses would be if interest rates shot up quickly by 1.5%. In its most recent annual report, Fannie claimed that if rates rose 1% on Dec. 31, it would have made $600 million. But, this estimate includes gains not directly related to mortgages. In fact, the computer model predicted a $2.6 billion loss, between the value of the mortgages it owns and the value of the debt it has issued.

Fannie has not indicated how much the recent jump in interest rates has affected the market value of its mortgage portfolio. "There is no reason for anybody to be worried about the company," claimed Peter Niculescu, executive vice president for Fannie's mortgage portfolio, because the company has moved aggressively to hedge its risk (e.g., using derivatives).

Bond and derivatives brokers say the company has not provided enough information to gauge its risk to abrupt swings in interest rates.

Ominously, Fannie is so highly leveraged, with more than $50 in debt for each $1 in equity capital, that its equity could be erased if its assets fell in value by less than 2%, according to its most recent annual report.

"The fact that they have not blown up in the past, doesn't mean that they're not going to blow up in the future," said Nassim Nicholas Taleb, a hedge-fund manager. Fannie Mae's computer models, he said, do not account for devastating jumps in interest rates.

Pension Funds Sue Freddie Mac Over Accounting Tricks

Freddie Mac has been sued by two states and a labor union pension fund, over bogus accounting practices. Combined lawsuits were filed Aug. 8 in Federal court in Manhattan by the West Virginia Investment Management Board, which lost about $1.8 million, and the Central States Teamster Fund, which lost about $8.2 million. Ohio Attorney General Jim Petro said he will file a lawsuit against Freddie Mac to recover funds lost by both the state teachers' and public employees' retirement systems, which lost an estimated $25 million. An auditor's report in July found that Freddie had cooked its books to smooth out earnings, which will result in a restatement upward by $1.5-4.5 billion.

Mortgage Rate Hikes Threaten Housing Price Deflation and Foreclosures

The recent, rapid surge in home mortgage rates could trigger a drop in housing prices, and cause home foreclosures to soar, especially in California and the Northeast United States, areas with huge home-price inflation, and high job losses, the Wall Street Journal reported Aug. 6. In places such as Silicon Valley, Manhattan, and the Boston-to-Washington corridor, home prices have often doubled or tripled, even after adjusting for (official) inflation, over the past 20 years. This boom has triggered massive borrowing against home equity, in order to pump up consumer spending; households have also relied on massive cash-out refinancing, as mortgage rates fell. These "overheated" real-estate markets, the Journal cautions, are extremely vulnerable to a drop in housing prices triggered by surging long-term interest rates. Prices are already declining in parts of Texas, Tennessee, and Iowa.

Were mortgage rates to continue rising, and housing prices to fall, many people who borrowed against their homes could wind up in default on their mortgages, with loans that they would be unable to repay even by selling their houses, warns David Leonhardt in the New York Times.

Throughout most of the nation's vast middle, he states, housing prices have risen only slightly ahead of inflation, leaving homeowners with little equity to borrow against. Households in these areas that become delinquent on mortgage payments, already cannot tap into their rising home equity to raise cash. Falling house prices would accelerate the rate of home foreclosures, the highest level being in the Midwest and Southeast.

Aviation Week Highlights Collapse of U.S. Machine-Tool Sector

In a three-page feature, headlined "Monkey Wrench," Aviation Week & Space Technology magazine on July 28 reviews "the longest downturn since the Great Depression" in the U.S. machine-tool sector, which is now becoming a real threat to the defense and aerospace sector. The most prominent case is the collapse of flagship Ingersoll Milling Machine Co. on April 22, "which sent a shock wave through the machine tool and aerospace industries." Ingersoll was supposed to produce custom-made machine tools for Lockheed Martin. The defense contractor desperately needs these machine tools to produce special parts for the Joint Strike Fighter, for which it won an $18.9 billion contract from the Pentagon. Efforts to maintain the production of these machine tools, in spite of the Ingersoll bankruptcy, failed. Even efforts by Lockheed Martin's attorneys, citing risks to national security, didn't help. On June 17, Lockheed hired Cincinnati Machine to produce the machine tools instead.

What is causing great worry in the aerospace and defense sector, however, is the fact that Cincinnati is now the single remaining U.S. company able to produce certain types of machine tools that are indispensable for the sector. And in line with the "Buy America" movement sponsored by the U.S. Congress—in particular, a provision in the defense authorization bill—imports from foreign machine-tool producers are no longer allowed in the production of any new U.S. weapon system.

The magazine summarizes the recent years' collapse of the U.S. machine-tool sector: Since 1999, the number of U.S. machine-tool firms represented by the Association for Manufacturing Technology (AMT) has dropped from 400 to 320. "In the last 18 months, 30 U.S. companies have liquidated, filed for bankruptcy or been sold." according to the AMT. "The U.S. formerly represented a $5 billion piece of the $36 billion total sales. In 2002, the U.S. either produced or purchased equipment overseas valued at $2.9 billion. China, the newcomer in the machine tool field, either built or acquired machine tools valued at $5.7 billion."

"Machine tool employment in the U.S. has been in steady decline for more than two decades," AMT notes. The peak was reached in 1980 with a workforce of 110,000. In 1998, the most recent peak sales year, employees already had declined to 61,000; currently, there are 41,000 in the workforce. The current down cycle in U.S. orders for machine tools has been the longest since the Great Depression."

Job-Cut Announcements Soared in July

The number of job cuts announced by U.S. employers skyrocketted 43% in July to 85,117, compared to the level in June, according to Challenger, Gray & Christmas, a Chicago-based employment firm. During January-July, U.S. firms announced 715,649 layoffs, only 12% lower than in the first seven months in 2002. In July, consumer products companies announced 15,665 layoffs; transportation firms, 9,820; government and non-profits, 9,369. Planned layoffs may take place immediately, or over a period of months.

Michigan Official Blasts Administration for Ignoring Manufacturing

"Manufacturing has lost 2.5 million jobs in the last two-and-a-half years, and it's a crisis here in the United States that has to be addressed," insisted Jim Donaldson, vice president of the Michigan Economic Development Corporation, the Detroit News reported Aug. 5. "There just needs to be more attention paid in D.C. as to how vital manufacturing is," he said, adding that Federal officials are babbling that if manufacturing vanishes, "we'll still be a strong, healthy country."

Donaldson called on the U.S. Department of Commerce to create an office of Undersecretary of Manufacturing to protect the interests of manufacturing companies. He was speaking on Aug. 4 at a major annual automotive industry conference in Traverse City, Michigan.

Michigan ranks in the top five of manufacturing states by employment, with more than 900,000 manufacturing workers—nearly 20% of the state's total workforce, according to the Michigan Manufacturers Association.

Ford Motor Co. said it will do more cost-cutting in 2004, beyond this year's $2.5 billion target, in order to offset the rising cost of incentives and the higher costs of building new models. The world's second-largest automaker had already cut $1.9 billion through June, and had announced in July a plan to cut 10% of its salaried job costs, including white-collar job cuts. But, "It is clear we will have to take further cost actions," warned vice chairman Allan Gilmour.

Dana Corp., a Dearborn-based auto-parts maker, announced it will close eight more factories or offices this year, as it completes an October 2001 cost-cutting plan. The world's largest maker of axles for pickup trucks, minivans and SUVs, already has shut down 31 plants and eliminated about 15,000 jobs, or 20% of its workforce.

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