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Banks have been reaping huge rewards from the refinancing boom. Everyone’s happy, financials are rallying. But there are some potentially nasty consequence from this feeding frenzy. I think one of the more serious side effects will be the degradation in quality of MBS. Default rates should rise significantly. The end result will likely be (surprise) yet another indirect bailout for Big Banks. One that will leave taxpayers holding an ever-growing bag. Follow my logic, and let me know if I’m missing something.

Anybody who can afford to refinance right now is a high-quality borrower, the kind banks love. You need a great credit score to refi these days, and cash to pay the fees. If you have an ARM, you’ll also need ~20% cash down to switch into a traditional loan. Meanwhile, homeowners who are underwater or behind on payments aren’t refinancing. So these “bad” loans will stay in the MBS they were bundled into. The same ones that taxpayers are destined to buy.

Quality of MBS Will Plunge

When you remove (via refinancing) the higher-quality loans from an MBS, what’s left isn’t pretty. The loans will have much higher default rates. So it’s easy to see why bankers are eager to do two things:

  1. keep rates low, to encourage refinancing to those who can afford it
  2. get these horrific assets off their books ASAP

Unloading the MBS

The Fed and Treasury are determined to unload these “legacy assets” on the American public. Whether it’s through TALF, FDIC, PPIP, or some other silly acronym, taxpayers will end up holding the bag. Unless Obama changes his economic team very soon, we will continue buying ever-larger quantities of these securities at inflated prices. Defaults continue to rise, so banks want as little exposure as possible to these assets. And remember, Alt-A and Option-Adjustable loans don’t peak until 2011, as this chart shows:

Mortgage Resets (click to enlarge)

Mortgage Reset Schedule (click to enlarge)

No matter what we do, the economic results will be disastrous. But it’s important to ensure the right people are held responsible for their actions (more on solutions below). Stealthy bailouts like this paint a somewhat rosier outlook for large banks. They have unlimited support from Geithner. Their smaller competitors are rapidly dying off, which will get worse soon. Many will be absorbed on the cheap.

The majority of losses will be absorbed through a complex web of bailouts. Some of the conduits are GSEs like Freddie Mac (FRE), FDIC insurance fund, pension fund insurance corp, automakers, insurers, and more. And the healthy (and recently refinanced) loans end up at TBTF banks. The same ones who basically control the Federal Reserve and (arguably) the Treasury.

The only way to fix it

Obama needs to fire his whole economic team. Geithner and Summers need to go ASAP. Get William Black or Simon Johnson in there stat. Bernanke needs to make a hasty exit as well. But that will be trickier. Only Congress has control over the Fed, and that is limited. If you want to do something, contact your congressmen and get them to support the Federal Reserve Transparency Act.

No matter what course of action we take, things are gonna be ugly. And our current plan only delays the inevitable, while shifting the burden onto the public, and away from responsible parties. It’s time to let some banks fail, take our medicine. To those who say it’s too big of a job, or too complex, I say that the alternative is much worse.

Disclosure: No positions in securities mentioned

Source: Refinancing Boom Will Degrade MBS Quality Causing Yet More Bank Bailouts