Market Recap

Up, up, and away – and thank goodness. The stock market soared on some very good news: Banks are beginning to make money. Beleaguered behemoth Citigroup said it will actually earn a profit this quarter, and so did almost-as-beleaguered Bank of America. They are recuperating so well, in fact, that both recently said to the feds, “Thanks for the money, but no thanks.” In response to the perception the banking sector could be turning the corner, the Dow Jones Industrial Average (which includes the aforementioned Citigroup and Bank of America) soared over 500 points.

Another reason the tide is turning for banks is more government officials and business people are turning against mark-to-market accounting, which requires that banks take hits on their troubled assets by marking these assets against perceived market value. The requirement can devastate balance sheets, and needlessly so. Here's why: Say you had bought rental property two years ago and you borrowed money to purchase your properties. The properties could be cash flowing positively, but their value will likely have dropped, and dropped enough that you would be underwater on the loans. If you were required to mark-to-market those properties on your balance sheet, you could appear to be insolvent, even though your properties are cash flowing positively.

It's frustrating for the banks because the system rests more on government guarantees than on its capital base. With these guarantees, banks are able to earn decent spreads above their cost of funds. Just give the banks some time, and they will earn their way out of their current predicament. Citigroup and Bank of America prove they already are.

A more profitable banking sector means the lending purse-strings should loosen even more. Indeed, we see that already occurring in mortgage lending, where money continues to be available at very good rates. Borrowers with better credit are still availing themselves of rates in the 5% to 5.5% range.

And let's not forget that the wind remains at home buyers' backs. Homebuilders are offering a plethora of incentives to move inventory (but that inventory is dwindling, so the incentives won't last forever). The foreclosure market also offers a wellspring of value. And that $8,000 buyer's credit? It's only available through December.

verything isn’t turning up roses quite yet, but last week’s slate of economic news suggests that at least blooms are forming. Existing-home sales hit a five-month high, according to new data from the National Association of Realtors, jumping 3.1% in July to 5 million units from 4.85 million in June.

Meanwhile, on the new-home front, sales rose 2.4% in July to a seasonally adjusted annual rate of 515,000 units after falling to a revised 17-year low in June, the Commerce Department reported. More encouraging, the inventory of unsold homes declined for the second month in a row, to a 10.1 months’ supply at the current sales pace. It appears that new home sales have begun to stabilize, as sharply reduced prices have lured buyers back into the market.

Prices on both existing and new homes should continue to stabilize along with the economy. On the latter, gross domestic product grew at a seasonally adjusted 3.3% annual rate during the second quarter, exceeding most economists’ estimates by over a percentage point. The new GDP numbers reflect new data showing that exports were even stronger than first estimated and that business inventories weren’t depleted as much as earlier thought.

Further proof of a recovering economy could be found in durable goods orders – products that have a life expectancy of at least three years, including cars, computers and aircraft. They increased 1.3% in July, matching June’s revised number. Economists had predicted orders would drop 0.5%. (Overall, it was a bad week for the professional prognosticators.)

Even long-suffering shareholders in Fannie Mae and Freddie Mac had something to cheer about. It seems that the prior week’s talk of nationalization may have been premature (but that doesn’t mean it won’t happen yet). An emerging sentiment among investors is that both institutions might still have a life as independents, which lifted both Fannie’s and Freddie’s stock 50% higher. (Keep in mind, though, it doesn’t take much price movement to produce big percentage swings in a low-priced stock.)

No Better Time than the Present

Some of the immediate government actions, such as the injection of capital into the banking system and guarantees given to investors and deposits, have helped ameliorate the financial crisis, but the proposed government incentives to modify loans or lower rates is really “too little, too late.” Worse yet, some of these proposed incentives are keeping too many people on the sidelines.

Many potential borrowers are out of the market because of the persistent and widespread rumor that the federal government will take mortgage rates down to 4%, but there is little evidence that the Federal Reserve and Treasury intend to reduce mortgage rates, and less evidence that they would be able to do it and hold rates lower for long. Too many people are overlooking the fact that today's rates are already at all-time lows. They are also overlooking the fact that good rates are available to borrowers of all stripes.

But these rates and other lending programs won't last forever. The government has injected massive amounts of liquidity (money) into the economy over the past six months. Massive amounts of liquidity, in turn, increase inflationary pressure, and that can very well lead to higher interest rates down the road.