It’s like watching a low pressure system develop in the Gulf of Mexico, that sense of dread.

Don’t look now but the energy price – interest rate price spiral is developing again.. Energy prices are prompting ‘inflation’ talk in credit markets and rising long term mortgage and interest rates are the consequence:

Mortgage Rates – It Could be as Bad as You Can Imagine

With respect to yesterday’s in the mortgage market — yes, it is as bad as you can imagine. No call can be made on the near-term, however, until we see where this settles out over the next week of so. If rates do stay in the mid 5%’s, the mortgage and housing market will encounter a sizable stumble. The following is not speculation. This is what happens when rates surge up in a short period of time – I lived this nightmare many times.

Yesterday, the mortgage market was so volatile that banks and mortgage bankers across the nation issued multiple midday price changes for the worse, leading many to ultimately shut down the ability to lock loans around 1pm PST. This is not uncommon over the past five months, but not that common either. Lenders that maintained the ability to lock loans had rates UP as much as 75bps in a single day. Jumbo GSE money — $417k – $729,750 — has been blown out completely with some lender’s at 8%. I have seen it all in the mortgage world — well, I thought I had.

A good friend in the center of all of the mortgage capital markets turmoil said to me yesterday “feels like they [the Fed] have lost the battle…pretty obvious from the start but kind of scary to live through it … today felt like LTCM with respect to liquidity.”

The consequences of 5.5% rates are enormous. Because of capacity issues and the long time line to actually fund a loan in this market, very few borrowers ever got the 4.25% to 4.75% perceived to be the prevailing rate range for everyone.

A significant percentage of loan applications (refis particularly) in the pipeline are submitted to the lenders without a rate lock. This is because consumers are incented by much better pricing to lock for a short period of time…12-30 day rate locks carry the best rates by a long shot. But to get this short-term rate lock, the loan has to be complete enough to draw loan documents, which has been taking 45-75 days over the past several months depending upon the lender’s time line. Therefore, millions of refi applications presently in the pipeline, on which lenders already spent a considerably amount of time and money processing, will never fund.

Furthermore, many of these ‘applicants’ with loans in process were awaiting the magical 4.5% rate before they lock — a large percentage of these suddenly died yesterday. From the lows of a month ago to today, rates are up 20%. To make matters worse, after 90-days much of the paperwork (much taken at the date of application) within the file becomes stale-dated and has to be re-done with new dates — if rates don’t come down quickly many will have to be canceled out of the lender’s system.

To add insult to near-mortal injury, unless this spike in rates corrects quickly, a large percentage of unlocked purchases and refis will have to be denied because at the higher interest rate level, borrowers do not qualify any longer. For the final groin kicker, a 5.5% rate just does not benefit nearly as many people as a 4.5%-5% rate does. Millions already have 5.25% to 5.75% fixed rates left over from 2002-2006.

So much for a housing recovery …

It’s easy to see the process in action now that everyone knows what to look for. The difference this time is the Funds rate/short term rates are low but long rates are high and jumping. The Fed’s plan was to buy long bonds and GSE paper (Fannie and Freddie mortgage bonds) and drive rates lower – to stimulate the housing market and support high (2006 legacy) prices. This plan backfired because the Fed is a small potato in the bond market. 

The Fed is a large if indirect player in commodities markets, however. The Fed aims its liquidity hose at real estate and energy winds up getting wet.

With the Fed still printing, broker- dealers (big companies like Goldman- Sachs) use the funds to buy oil futures. Index funds jump in – the market is going up, after all. The index funds are also supported by Fed liquidity. Add some velocity as G-S and PIMCO or Citi start selling contracts back and forth and $100 oil is a few short months away. Like August???

There is the also the ‘supply’ issue as the Treasury is seeking to fund the bailout machine to the tune of trillions of new debt issue. Much of this is short term – five years or less. Traders are looking at debt issue and putting it into the context of commodities and seeing inflation. Remember, it’s not the fundamentals that matter – we are still in deflation – it’s the appearance of fundamentals. Buy the rumor, sell the fact.

Gasahol prices jumped 40 cents here in the South last month. Anything is possible. There are plenty oil bears to keep the markets balanced – people who can take the other side of bullish positions. Only when all are oil bulls will this market crack. This might be over $150!

Oil price checklist:

– Lotsa oil bears … check
– Strong long term fundamentals (peak oil!) … check
– Ignorable short term fundamentals … check
– Available investment cash … check
– Lack of energy policy … check
– Large open interest … check
– Not so much OPEC cheating … check
– Apparent ‘Increased Asian demand’ … check

All it will take is a political crisis in Iran or Saudi Arabia and the lid will pop right off.

BTW, watch the grains. I think grains will skyrocket. Go long on ‘Food Riots’.