Fed’s Conflicting Recovery Agenda. Wells, Morgan Earnings. Derivatives 101.

Fed’s Conflicting Recovery Agenda
The Federal Reserve Bank of New York has joined forces with BlackRock, PIMCO and other major bond investors in trying to force Bank of America to repurchase $47b of mortgages that were packaged into securities. Bank of America defended its position. “We’re not responsible for the poor performance of loans as a result of a bad economy,” the bank said in a statement. In this Bloomberg video, Lisa Welch of MFC Global Investment Management says the $47b buyback figure is overstated.

Nevertheless, this just adds to market uncertainty, keeps mortgage-related stocks down, and makes lenders continue to believe that holding on to cash (rather than lend it out) makes sense. The Federal government can run quantitative easing all it wants, but until large lenders and investors feel comfortable enough to come out of their shells, the housing market may not rally to any great extent. It also illustrates conflicting policy priorities, because it could put the Fed at odds with a bank the Treasury Department has been helping through the financial crisis over the past two years.

What is a Derivative?
A derivative is a financial instrument that has a value determined by the price of something else. They are not “bad” things, and in fact in many cases promote liquidity as the value linked to the expected future price movements of the asset to which it is linked. There are many kinds of derivatives, with the most notable being swaps, futures, and options. Over-the-counter derivatives are important risk-management tools for companies worldwide. Companies use OTC derivatives to manage exposure to interest rates, currency-exchange rates, commodity prices and other risks inherent in their business.

Because commercial and industrial companies use derivatives in this manner, they can devote time and attention to what they do best: producing and providing medical equipment, clothing, floor covering, mortgages, and other goods and services. For mortgage bankers and other financial firms, they can use credit default swaps to manage their exposure to credit risk in an efficient and cost-effective manner, which makes loans more available and less expensive to businesses and consumers. Because credit default swaps played a role in problems encountered by a small number of insurers, including AIG, policymakers at the federal and state levels are considering steps that can be taken to reduce the risk of similar problems arising in the future. And if it helps mortgage bankers, let’s do it.

Wells, Morgan Earnings
Both Morgan Stanley and Wells Fargo issued their 3rd quarter earnings this morning. Both stocks are down on the news, although the numbers generally came in close to expectations. For Wells, non-performing loans were up modestly. WF had record earnings, and said it has no plans on freezing their foreclosure process. Morgan Stanley announced that it will spin off its $7 billion hedge fund business that it purchased in 2006.

Mortgage Apps Down
Last week’s mortgage application index (with numbers from the week before) had a nice boost, but this morning’s MBA announcement showed that last week’s applications dropped 10.5%. The decline was the largest in four months, with refi’s down about 11% and purchases down about 7%. As folks in the business know, despite low rates or quantitative easing by the Fed, unless a borrower has the equity or qualifies using current guidelines it doesn’t matter what rates are.

Rates Up A Bit After Yesterday
Yesterday rates improved but despite favorable earnings reports (BofA and Goldman) and stronger than expected Housing Starts, stocks sold off throughout the day with acceleration as the afternoon moved on news that PIMCO, BlackRock, the New York Federal Reserve Bank, and others were suing BofA to take back millions in RMBS related to misrepresentations (see above). The 10-year note, which at one point was down (worse) by about .625 in price, ended better by .125 at 2.48%. Mortgage-backed securities improved roughly .250 in price, and most investors had one or more price improvements but Tuesday was the 2nd day of light supply – where are those locks? Besides the MBA application numbers, we have the Fed’s Beige Book later this morning, so it is pretty quiet out there. The 10-yr is sitting around 2.51% and mortgages are worse between .125-.250, giving back some of yesterday’s gains.