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Non-Tech : NDE: IndyMac Bancorp, Inc.

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From: D.Austin	11/21/2002 4:26:00 PM
	of 4

Dr. Greenspan has been repeating his promise to buy long term treasuries if the economy needs it. I addressed this in the past but am going to address again here. What he is saying is that he will use Federal Reserve reserves to buy 10 year treasuries from the open market and most importantly from the member banks. This reduces the number of treasuries available for other purchasers and makes each treasury worth more as a result. This allows the sellers to offer lower yields to the new buyers and still be able to sell them. Simple supply and demand at work. As the yield on the 10 year treasury falls all other rates that are tied to it fall. Because it is a peg for many loan rates these loan rates will also fall. The loan rate that is tied to the 10 year treasury yield that has the largest impact on the economy is the 30 year fixed rate mortgage rate. When Dr. Greenspan says he is ready and willing to buy long treasuries to stimulate the economy what he means is that he will manipulate mortgage rates down to attract new buyers into housing and cause another refinance boom. The 30 year fixed rate mortgage accounts for about 65% of all mortgage loans in the US. The rate on that loan is determined by the cost of borrowing money at Fannie Mae and Freddie Mac. Their borrowing cost is determined by the yield on the 10 year treasury. That rate will be the 10 year treasury yield plus a risk premium for lending money to Fannie and Freddie versus lending money to the US government. As the yields on the 10 year US treasury fall lenders to Fannie and Freddie are willing to accept a corresponding reduction in rate they will accept from Fannie and Freddie for lending money to them as well. Fannie and Freddie then pass this reduction on to the banking and mortgage industry in the form of lower PAR rates or cost of money for mortgages. The banking and mortgage industry then pass this reduction on to each of us as home owners by way of lower mortgage rates. This process has been going in a passive manner for the past year, as the Fed has indirectly been the cause of lower mortgage rate over the course of this year. I will explain. For the past year the Fed has been increasing money supply by buying treasuries form the banks and replacing them with cash. The banks in turn have been turning around and re-buying treasuries on the open market. The result has been lower long term rates and a refinance boom in the US housing market. That however was not the primary intention. The primary intention was to encourage banks to lend and for corporations to borrow; which has not occurred. The reduction in mortgage rates during this period of time was a bonus that helped consumers to support the economy as the Fed attempted to get corporations to borrow. Dr. Greenspan appears now to be taking an "if you can't beat them join them attitude". He has shifted Fed policy to become preemptive on deflation and aggressively move rates down ahead of the economic contraction and is now preemptively telling the market he is going to move out on the yield curve and buy long treasuries with the explicit goal of driving mortgage rates down. I do not believe this is a bluff or psychological game on his part. I believe this is a well choreographed plan by the Fed, Treasury and the GSE's to attempt to manipulate the economic cycle. The reason he is being so vocal about his intentions to buy long term treasuries is to ensure hedge funds and most importantly the GSE's are hedged against falling rates before it occurs. It is a warning or "heads up" so to speak to them. Remember this past Summer the duration gap problem at Fannie Mae. The duration gap problem was the direct result of Fannie Mae not anticipating that the 10 year treasury yield would go below 4%. When it did their duration gap widened and they lost enormous amounts of money. The reason they were not properly hedged is that they anticipated that the reduction in Fed Funds and corresponding increase in money supply would depreciate the dollar and increase the potential for future inflation in the US economy which would have been reflected in rising 10 year treasury yields rather than falling. But, because the corporations refused to borrow and banks refused to lend and the rest of the world continued to buy treasuries on a flight out of their own countries markets the yields actually fell and the dollar did not depreciate against the Yen and Euro. This was the first major international empirical signal that this was not the same type of economic contraction that we have experienced since the end of WW2. Every other post war recession has been the result of the Fed maintaining too tight a monetary policy as they preemptively tried to predict and stop inflation. In other words the Fed caused every other post WW2 recession up to and with the exception of this one. That is also why every time the Fed lowers the equity traders buy stock. This is why we are getting this exaggerated volatility in the stock market. The traders today have never experienced a market that occurs during a true economic cycle contraction rather than a Fed induced contraction. They are confused. This recession is the economic cycle. It has never been stopped by monetary policy before. Dr. Greenspan's last hoorah as Chairman is apparently going to be to be the first Central Banker in world history to succeed in superceding the cycle. That means he is not only going to be preemptive but aggressive. This is the equivalent of slamming the accelerator down when the light turns yellow as you attempt to get through the light before it turns red and hope you don't get broad sided by cross traffic. Caution has been thrown to the wind it appears. The next question is will he succeed in the first goal of actually driving down mortgage rates. He can clearly drive down treasury yields. But, will mortgage rates follow. I believe they will. I believe that the Fed has already had several meetings to gain an indication of interest in this attempt by bankers all over the world. I don't think he is maverick enough to attempt to do this without the support of the worlds central bankers, money centers, insurance companies and the GSE's, Fannie Mae, Freddie Mac and the Federal Home Loan Banks. Roger Arnold

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