Fed’s Act II: Will It Play as Well as Act I?

by: Sy Harding

In its efforts to rescue the economy from the worst recession since the Great Depression, a recession so severe it will go down in history as the Great Recession, the government, and particularly the Federal Reserve, employed dramatic rescue methods never before attempted.

Critics were sure the actions taken would not work. The problems were too serious and embedded.

So far however (if we don’t look too far down the road for potential future problems the rescue efforts may have created), the results have been close to miraculous. The Great Recession ended in the 3rd quarter of last year.

Now the Fed has decided the time has come for Act II, reversing the unusual rescue efforts.

Act II will no doubt take more finesse and delicate maneuvering than the panicked and crude flooding of the financial system with excess liquidity, and dropping interest rates to near zero.

And critics say it’s too early to try it, that it will slow the fragile economic recovery back into a double-dip recession.

However, the Fed thinks otherwise and has begun Act II. At least from the outside, the first scene seems heavy-footed, ending its massive 15-month program of purchasing mortgage-related securities cold-turkey. It cut its purchases by half early in the month and ended them completely on March 31.

The Fed is confident investors are ready to take back their traditional role of supporting the housing industry by buying its mortgages. Let’s hope so. And I assume they checked with potential buyers before making the move.

Prior to the financial crisis and freeze-up of credit, institutional investors, including pension plans, banks, and hedge funds, as well as private investors, were keen to buy any and all mortgage-related securities. Banks and other lenders eagerly sliced the mortgages they issued into various risk ‘tranches’, set them up in packages, and sold them to those eager investors.

When the sub-prime mortgage market imploded and losses mounted, it was suddenly realized that no one, neither lenders nor investors, knew the actual value, or risk, of what were in those sliced-up mortgage packages. The result was ‘Toxic, Do Not Touch’ labels placed on anything related to investing in mortgages. The entire financial system froze up as a result. Major financial institutions, hedge funds, and investors had no clue to the value, if any, of the ‘toxic waste’ on their balance sheets, as there was no market for them.

The Fed stepped in with its massive mortgage purchase program. By the end of last month, when it ended the program the Fed had more than $1.2 trillion in those investments. Its purchases have been primarily in mortgage-backed securities tied to the better documented new mortgages issued by Fannie Mae (FNM) and Freddie Mac (FRE).

It seems like a lot to expect institutional investors to entirely replace the Fed’s massive activity. By some estimates the Fed had been buying 90% of new mortgage-backed securities for some time, and in the process has become the largest investor in mortgage-backed investments in the world.

It is earning roughly $50 billion a year from the mortgage interest home-owners are paying on the mortgages.

However, there is still a question of how much such investments are worth, especially given that the largest buyer by far has been the Federal Reserve, and it will no longer be in the market. And of course there is the question of what will happen to the value down the road if mortgage defaults and foreclosures continue to rise, and when the Fed eventually begins to unload those holdings to get its money back.

Meanwhile, it has been expected that mortgage rates will begin to rise with the end of the Fed’s support program. And indeed, the rate on 30-year mortgages popped above 5% this week after an extended period below 5%.

Yet rising mortgage rates could be at least a short-term plus for the housing industry as it enters the all important spring home-buying season. The sight of rates rising could prompt potential buyers waiting for lower home prices to get off the fence and buy before rates move even higher.

I have my doubts, especially with the equally important program of rebates to first-time home buyers due to end at the end of this month.

But then I was dubious about how the Fed’s first act would play out.

Disclosure: No positions