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To: Jim Willie CB who wrote (8454)	10/25/2002 11:02:31 AM
From: stockman_scott	Read Replies (2) \| Respond to of 89467

OPINION - U.S. Mortgages and Rates by David Beadle Friday October 25, 10:55 am ET By David Beadle, mortgage industry analyst, BestRates Inc. NEW YORK, Oct 25 (Reuters) - A lot has been made recently of the possibility we may be facing a deflationary spiral. In theory, that should be good news for those seeking lower mortgage rates, even though deflation could be very bad news for the U.S. economy. Deflation is triggered by an overabundance of goods and services met with little demand from consumers. In order to keep the factories humming, manufacturers are forced to lower prices to a level where shoppers cannot resist the bargains. And the best domestic example of the trend is the drop in mortgage rates seen for the past half year. Thanks to the Federal Reserve Board, there is plenty of cash sloshing around in the pipeline. The problem is that businesses don't need the money for capital expenditures. Why? Because factories are currently only operating at roughly 75 percent of capacity, so there is little demand for expansion capital. Many companies which do wish to borrow funds for continuing operations in a tough sales environment are finding the asking price for money is astronomical. Investors are demanding a double-digit return on their cash, because of uncertainties about the integrity of corporate balance sheets in the wake of all the recent scandals and restatements of earnings. The major bond rating agencies are issuing more downgrades than upgrades, and only the highest rated firms are able to receive rates below 10 percent when they issue IOUs. In sharp contrast, home mortgage rates are near 40-year lows. There are two primary reasons for this divergence. The first is that investors perceive home equity as being among the safest places for their cash in troubled times, and a much better alternative than lending to businesses. The second reason is the perception that the two major buyers and consolidators of mortgages have an implicit government guarantee if property values were to plunge and home owners began defaulting on their loans in large numbers. However, in recent months, this latter assumption of a government bailout of mortgage investors if a full blown crisis were to occur has been questioned by at least one congressional committee. And for that reason, there has been a shift by some money managers into FHA and VA mortgage backed securities. The result has been a faster drop in Federal Housing Administration (FHA) and Veteran Administration (VA) loan rates than standard loan rates. The one situation which has historically frightened the bond market has been one where prices are rapidly rising, otherwise known as inflation. Generally, upward price pressures have prompted investors to demand a "premium" on their rate of return, to offset inflationary expectations. For instance, if a certificate of deposit at the bank is paying 3 percent and inflation is running at zero percent, the "real" rate of return is 3 percent. But if inflation is 3 percent, the "real" rate of return after accounting for inflation is zero. Therefore, in a 3 percent inflationary environment, investors often demand a 3 percent buffer, which would put that certificate of deposit at 6 percent, to provide a real rate of return of 3 percent. But if the price of oil as a result of a new Gulf War were to spike from the current roughly $30 price to perhaps $40 or $50, mortgage rates might not rise. In fact, they could even decline. The reason is simple. The price of oil is now seen as an extra "tax" on consumers when they fill up at the gasoline station. And that's money which won't be spent at the department store on holiday gifts. Thus, the economy could suffer another blow, which would bring about the specter of rampant deflation. And as we've already seen, deflation usually pushes mortgage rates lower. In summary, we appear to be in a potential "win/win" situation, when it comes to the interest rate environment. Prices go down, and rates go down. Oil prices go up, and rates go down. But there are risks. The biggest one is a ballooning government deficit to pay for the war effort. In that scenario, the U.S. Treasury would be borrowing a huge amount of money and this set of circumstances would almost certainly put upward pressure on rates, as there would be fewer investor dollars left to finance home loans. The question is whether or not the economy would slow sufficiently to offset the impact. As we get into the new week, here are what some key indicators are telling us. A plus (+) sign means the category is on the side of lower interest rates, a minus (-) sign means the forecast is for higher rates, and a zero (0) means the item is giving a neutral reading. Key Indicators 0 Treasury Yields 0 Currencies 0 Inflation 0 Energy Prices 0 Precious Metals 0 Chart Patterns (Note: The opinions expressed here are those of the author. They should not be seen as representing the views of Reuters.)