Crisis Contained as Fed Purchases Mortgage Backed Securities

The purchase of mortgage backed securities (MBS) by the Fed means that the exposure to risks posed by further defaults on home mortgages will be shifted from the lending institutions to the Fed. Further erosions on the balance sheets of the lending institutions resulting from a continuing slip in home prices will then be contained, laying the groundwork for a full recovery of the economy by year end.

Compared to my earlier proposal to contain the damage to the financials by putting a floor to home prices through a buy-back program for existing homes below the median price, this initiative is also effective, even though further slips in home prices will continue to hamper consumption and lead to further losses on consumer loans. Whereas my proposed buy-back program offers buy-back from existing home owners at the "snap-shot prices" at a designated point in time, the purchase of MBS by the Fed allows banks that still hold MBS to sell these assets at the "snap shot" valuations as at the time of the purchase. This effectively protects banks from further erosion of their balance sheet positions due to further price declines.

For this reason, a major source of credit crunch is removed. There is a good chance that banks will start lending again before long. Together with continuing efforts to forestall foreclosures and efforts to keep mortgage lending rates low, there is even a good chance that home prices will stabilize by mid year.

Provided that oil prices do not surge again, and stay around $40 a barrel, the "dividend" from soft oil prices will prove to be a significant booster for consumption. 2009 will prove not as bad as many doomsayers predict. I am hopeful the economic recovery will come sooner than most people expect.

Comments

[Asbytec:]

I agree getting toxic debt off the banks balance sheets is a step in the right direction, more so than that interest rate cut to zero percent.

Also, getting asset values to stop falling, well, that's a bit harder. It's more than just home prices falling. AIG sold off it's boiler insurance arm at a pretty substantial loss. Deleveraging is painful, but necessary at times.

I agree in principle with your mortgage buy out plan. Like you, I argued heavily for a bottom up bail out to save home mortgages. Ah, but we all know how that fiasco ended up...we gave Wall Street our tax dollars so they could loan us our own money back...at interest.

You know, the big financials should have been allowed to fail, put our money in our hands and let surviving banks pay us interest on our own money instead of the other way around. But, the point is mute, that money is gone.

So, once toxic debt is removed, a big obstacle to inter bank lending will be removed. Now, let's see if banks want to loan on a home that will devalue over time. They might. Let's see if anyone will buy. Again, they might.

If so, we might see a turn around by mid year. But, that'll be a bit soon in the deleveraging cycle, in my view...it needs to run it's course. If we see a turn around by mid year, we're likely to see a period of high inflation. So, we'll have that to contend with.

And, if we begin to recover too early we'll soon be back to being debt top heavy. So, we may have bought some time, but we may...i say may...have just postponed the natural end of business cycle correction by a decade, give or take.

Jan 01 08:37 AM

[User 143167:]

"Oil keeps at low while house price moves higher" - This is the wet dream of the government, but never will happen in the real life in the foreseeable future. The government can manupilate the money supply but can not manupilate the money flow's preferences of the markets they want to invest in. This is an either inflation or deflation choice, no other way out.

Jan 01 09:48 AM

[Lonestar1:]

The Fed's purchase of MBS is not going to work because such actions would cause great confusion in the pricing of MBS. Clearly the Fed would greatly overprice the MBS, while any sensible private investor would seek deals similar to the one done by Lone Star/Merrill Lynch. The net result is likely to be that while the Fed is actively buying MBS or ABS, etc, private investors would just sit there and watch. The crunch may get worse.

Similarly, another $20bn injection into GM would make anybody buy GM stock? A walking deadbody can not be revived.

Jan 01 09:57 AM

[Rob Viglione:]

As stated in this article, "exposure to risks posed by further defaults on home mortgages will be shifted from the lending institutions to the Fed."

The cost of these risks has not disappeared, but has merely been "socialized". In other words, those who had nothing to do with the bad business decisions are now suffering the consequences.

Playing the social engineering game is easy from the sidelines; at some point we must ask the question of whether or not this is good for the country's long term health, and even more importantly, is it morally justifiable to take and redistribute other peoples' property? I contend that it was this mentality that caused this financial crisis. More of the same will ensure we head down this path once again...

Jan 01 10:47 AM

[secmaven:]

This is not new money coming into the mortgage pool. The Fed is just taking the Chinese off the hook! Their next Chinese support program will be the purchase of trillions of government bonds. Funny money anyone?

Jan 01 12:18 PM

[PeakOiler:]

While I appreciate the thrust by the Fed to de-lever the balance sheets of financial corporations thus reducing the deer-in-the-headlights reaction and hopefully get commerce working again, the Fed is simply transferring that leverage to their own balance sheet. Presumably this is like smoothing the wild ocean waves for corporations, but could the Titanic Fed still hit an iceberg? After all, it was eerily calm when the Titanic sank in the North Atlantic.

I'm just guessing at this, the likelihood is that there is no way out of this balance sheet musical chairs game other than much increased inflation down the road, ie. Fed balance sheet repair by an extra 2 points more inflation per year, and slower growth. Commodities anyone?

Jan 01 12:39 PM

[johnny a:]

wake up!!!! at the proper time the g-20 will sit down with port and cigars. conversation----DEVALU... currencies 25% together. Problem ends. start new game

Jan 01 06:23 PM

[{5U}:]

Amen. Well said.


On Jan 01 10:47 AM Rob Viglione wrote:

> As stated in this article, "exposure to risks posed by further defaults
> on home mortgages will be shifted from the lending institutions to
> the Fed."
>
> The cost of these risks has not disappeared, but has merely been
> "socialized"... In other words, those who had nothing to do with
> the bad business decisions are now suffering the consequences.<br/&g...
>
> Playing the social engineering game is easy from the sidelines; at
> some point we must ask the question of whether or not this is good
> for the country's long term health, and even more importantly, is
> it morally justifiable to take and redistribute other peoples' property?
> I contend that it was this mentality that caused this financial crisis.
> More of the same will ensure we head down this path once again...
>

Jan 01 07:29 PM

[Moon Kil Woong:]

100% with the posters on this. It's not going to encourage borrowers to buy houses more, will not make lenders lend more or ease credit, and is essentially another bank givaway in disguise. It's like a New Years going away gift by the powers that be exiting the financial stage.

I want to clap that they are going and cry that they are doing yet another worthless imbicilic thing. They just can't take their hands out of the cookie jar can they? They just can't leave anything undemolished to the new administration can they. I am just thankful they haven't attacked Iran or pushed the button yet. Yikes... I hope they don't get any last minute suggestions from me. But I'm 100% that Bush Jr. couldn't read and understand 99% of what's posted on Seeking Alpha. It's way above his head. What a dissapointment he is to a more fiscally conservative, more prudent, and less warmonering Bush Sr.....

Jan 01 08:28 PM

[RJMoran:]

I'm NOT sure that a coordinated currency devaluation (-25% or more) would 'solve the problem'... Something will have to happen soon or this 'calm' you refer to will just be the momentary plateau before the markets REALLY tank...!

Jan 01 09:31 PM

[acudoc:]

I don't appreciate a damn thing the FED is doing, because all it can do is create money by creating more debt. In an economy strapped by too much debt, how is creating more helpful? A complete overhaul of the fractional-reserve, debt-based money system is in order. It was created by an act of Congress in 1913, rolling over as usual to special interests back then as now. You can't keep re-arranging deck chairs on the Titanic. The debt-based money system is a creature with voracious tentacles. Put a knife in its heart already and let a treasury-based money system emerge that is not interest-bearing and that is not managed by a fractional-reserve banking cartel that is strangling the world. And while we're at it, insist that that lame body of men called the House and Senate balance the Federal budget, just as everyone else has to do in their respective households when they don't have access to a debt-money machine that turns the American people into indentured servants!

Jan 02 12:48 AM

[Kunst:]

The FED is buying mortgage backed securities. At what price(s)? A lot of these are degraded assets. Is the Fed buying them at face value? At some kind of market value (determined how?)? It seems that Bernanke has the Midas touch. He can turn crud (MBS, etc) into gold (treasuries or cash). When those assets eventually get marked, and then sold, to market, the taxpayers are going to pick up the loss.

Jan 02 02:55 AM

[LeoNYC:]

I wonder why the treasury yields (for both 10yr and 30yr) went up on Friday and today after this announcements. The average mortgage rates went up slightly as well. One would expect the opposite effect.

Jan 02 05:55 PM

[Kunst:]

The Fed has artificially pushed interest rates down. Like a balloon forced under water, they could come shooting back up if the Fed chooses, or loses control.

Jan 03 02:24 AM