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The meltdown in the subprime mortgage markets began the week of August 10, 2007. The stock market was down over 100 points that Friday. Bullish numbers in the USDA report were ignored as selling hit the stock market and commodity markets hard.

Let's review the short-term impact and events of the past few months and consider what is to come.

  • On August 16, the 350-point drop in the Dow Jones took corn and soybean prices down nearly the limit before end users and commercials stepped in to buy the lower-priced grains. (See the soybeans weekly chart at right and note the mid-August subprime low).
  • European, Japanese, and Australian central banks stepped in on August 16 and 17 to provide $320 billion in liquidity to the U.S. banking system to keep an equity meltdown from spreading throughout the world.
  • The Federal Reserve Board dropped short-term interest rates .5% in an emergency meeting August 17.
  • In October and December, short-term interest rates were cut by .25% with short-term interest rates now down one percent since August. Odds favor several additional cuts in the Fed fund rate in early 2008.
  • Lower short-term interest rates dropped the U.S. dollar by 8% from August 2007 into the fourth quarter of 2007.
  • The Dow Jones rallied from the August low to an October high before chopping lower into the fourth quarter of 2007. (See the Dow Jones Daily chart) Equity prices will struggle until this mortgage mess is cleaned up.
  • Lower short-term interest rates and the potential for a slowdown in the U.S. housing market dropped home and farm real estate mortgages by .5% in the last six months. Odds favor lower rates for at least the first six months of 2008. As long as the rally in 10-year T-notes continues, mortgage rates will keep dropping.

Greed. The huge increase in urban real estate values created an atmosphere of home and condo prices moving higher forever. The mortgage industry began making creative (high-risk) mortgages based on the profit they could make instead of making mortgages a borrower could pay. These mortgages were packaged and given new names like collateralized debt obligations (CDO) or structured investment vehicles, then sold to Wall Street firms. These firms made billions packaging the mortgages into securities and then trading them.

When inappropriate mortgages were made and the real estate market began to fall, the default rate started to increase on the high-risk mortgages. As home values fell sharply lower, defaults increased.

Valuing CDO became difficult and at times impossible. Buyers disappeared, and the investments became impossible to trade or sell.

When the leveraged hedge funds and investment firms began to sell, values spiraled down. Firms with billion-dollar margin calls couldn't liquidate CDO, so they sold out of their long commodity positions.

Over $100 billion has been lost in this derivative market, mainly by banks and investment funds throughout the world.

Is the subprime crisis over? I don't think so. Odds favor another round of defaults and write-downs in the first and second quarters of 2008. In May and June 2008, the largest number of borrowers will see their interest rates jump substantially higher on subprime home mortgages.

After a 20-year rally in the urban real estate market, it's unrealistic to think the correction will take less than six months. The indicators I work with suggest a potential low in the housing market and securities by August to November of 2008.

  1. All this is negative to the U.S. dollar. It will likely take additional Federal Reserve intervention to keep the large U.S. banks liquid.
  2. Commodity prices will likely work higher as investors review the return on commodity prices over the last decade compared to equity markets.
  3. Farm real estate values will continue higher as investors factor in higher commodity prices and the trend in farm real estate prices.
  4. Farmland real estate mortgages are now available at rates equal to or less than home mortgages.
  5. Inflation will likely increase as extra liquidity and higher commodity prices ripple through the economy.

Stay disciplined in your grain sales. The global and U.S. fundamentals are positive, but if the equity market drops hard, that selling carries over into the grain markets.

Be cautious in farm real estate. A lot of commodity cycles are 28 to 30 years low-to-low and high-to-high. You don't want to buy into this rally 28 years after the last major high.

Avoid variable interest rates. As inflation increases, investors will demand higher interest rates on long-term bonds. This will increase real estate mortgage rates. Use any additional drop in long-term rates in early 2008 to lock in lower rates.

The meltdown in the subprime mortgage markets began the week of August 10, 2007. The stock market was down over 100 points that Friday. Bullish numbers in the USDA report were ignored as selling hit the stock market and commodity markets hard.

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