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Market Commentary

Report from Leen’s Lodge
June 23, 2013 David R. Kotok, Chairman and Chief Investment Officer

A few of us were sitting around after a day of fishing on pristine waters, with marvelous weather and wonderful conversation here in Maine. We discussed the results of Fed (Federal Reserve) policy and its impact on the housing market.

I was fortunate enough to gather with Ed Pinto, Josh Rosner, and Chris Whalen. They have great expertise in housing, housing finance, mortgaging, impacts of the Fed on the banking system, and the regulatory regimes that are affecting the country. Those three have had their share of experiences with congressional testimony and analysis. Regular readers and viewers of economic and financial television will recognize them.

The mortgage interest rate in the US is up about 100 basis points in a brief time, thanks to the failed communication policy of the Fed. What does that rise mean?

We speculated about how much of a setback will occur to the housing recovery. We know refinancing will come to a stop. Rosner pointed out that a large number of people in the market were cash and speculative buyers. That activity may slow down or come to a stop.

The salvaging of the foreclosure document mess will slow. Chris Whalen has done serious work on that. His firm, Carrington Holding Company, is involved in the mortgage servicing process.

Ed Pinto has been all over the issues involving FHA (the Federal Housing Administration), another mess in the making.

The takeaway from the group and others gathering here at Leen’s Lodge is pretty clear. Housing, finance, mortgaging, and the recovery in the US will see a setback. How severe that setback will be remains to be seen. The range of outcomes may span several hundred thousand single-family housing starts a year. The news is not good. The economy is likely to slow because of the slowdown in the housing recovery. The policy options available to the Fed are likely to become more difficult.

What is the Fed going to do if housing slows and we get well under two-percent GDP growth rates because of that? What happens to the incipient recovery in terms of consumer discretion? What happens to job creation in the housing sector, which offers higher-paying jobs? Is the Fed about to repeat its 1937 mistake of too-quick tightening? In 1937 the Fed did not have to deal with the balance sheet side and escrow reserve deposit rates. Policy was made differently then. However, the ramifications of imposing a serious shock on a recovering economy may be quite similar.

We talked about inflationary pressures under these circumstances. Whether or not St. Louis Fed President Jim Bullard is right on the mark by worrying about inflation was a high point of our discussion.

The conclusions from this early visit to Leen’s Lodge are these: Uncertainty and risk to the recovery are higher than they were a few weeks ago. The housing finance mechanism in the US is not fixed. There is a lot more to be done.

We think lower interest rates are going to be with us for a while longer. The combination of two rounds of communication confusion plus President Obama’s comments about Ben Bernanke have put the Fed in a position where its message requires greater clarification.

The fishing was good at Leen’s Lodge. The small-mouth bass cooperated. Food was delicious, and the 28 people assembled had lots of fun.

The takeaway for the economic outlook on the other hand, was a sobering counterpoint to the pleasures of our gathering: slow rather than robust growth coupled with low interest rates, and for a long time. As we have said repeatedly, we expect low rates for at least several more years. They are bullish for asset classes over time, and rising asset prices are good for investors.

In the real economy on Main Street, the circumstances are different. If you want to buy a house in the US and you need a conventional mortgage, and if you are not a speculator and want to live in dwelling, your costs have now risen substantially.

David R. Kotok, Chairman and Chief Investment Officer

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