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The Pollyanna Principle part 2: Banks are not necessarily passing rate cuts on

Click here to buy - A How To Book of SMSF's by Tony Negline

Lester Wills

Last time I mentioned how the first six months of 2008 could not exactly be described as good in economic terms. I also mentioned how some are optimistic despite that. This time I consider where we go from here.

The year started with the gloom of the sub prime crisis really starting to hit home and the flow on effect into the credit markets. Things are not really much different now. Just recently the US Mortgage Bankers Association quarterly report showed that almost 6.4% of mortgage borrowers were in areas on their payments. This was the highest figure since they began recording such things. But, and here is the rub, it's not just sub prime.

In Q1 2008, 36% of all foreclosures were on prime, adjustable-rate mortgages. The chief economist of Moody's Economy.com, said the decline in home prices has cut approximately US$2.5 trillion from household wealth. That translates to around US$25,000 for each homeowner.

As I mentioned in previous articles, much of the consumer boom in the US has been driven by increased debt, in particular, by people refinancing their houses based on increased property prices, drawing down money from the mortgage and spending it. Now that house prices have fallen and are continuing to fall, that source of income is no longer available. Of course once the hot and smelly stuff finally hit the fan, the excesses in lending practices stopped and many are in the process of (trying) to clean up the mess.

However, it turns out that the same sort fuzzy logic (I am being kind) that had been applied to housing finance was also applied in commercial lending and loans to private-equity firms.

Between 2004 and 2007, the US Federal Deposit Insurance Corp (FDIC) went without a single bank failure. Thus far in 2008, 4 banks have gone under. As Newsweek recently reported, FDIC chairperson Sheila Bair warned of the "possibility that future failures could include institutions of greater size than we have seen in the recent past." In preparation, the FDIC has brought people back to work from retirement. Does not sound promising.....

One issue that has been highlighted over here, and I seem to recall similar things happening in Oz before I left, is that banks are not necessarily passing rate cuts on to customers. The reason is that that are desperately trying to shore up balance sheets and make up for losses, rather than releasing the cash into the economy. There is all sorts of evidence that many institutions are tightening lending standards. Not to be too sanguine on the matter, but it seems a little like shutting the barn door after the horse has bolted.

Of course what this means is that the benefits of any rate cuts is not going to the intended recipients, consumers. New figures indicate that rates on many mortgages have only fallen slightly, if at all. If that was not bad enough, the Fed has indicated that 9it may not be cutting rates any more in the near future due to inflation fears, due in no small part to high energy costs.

Whilst there is an inevitable delay between interest rates being cut and their effects being seen, tax rebates normally make themselves felt relatively quickly. In this regard there is some good news and there is some bad news. There are reports of a surge of business spurred by the tax rebates, which is the good news. The bad news is that people are using the money for necessities, not discretionary items. The chief economist at Merrill Lynch suggests that higher food and petrol/gas prices are the reason.

I seem to remember suggesting that might happen a while ago (in edition number 276 to be exact).

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