Why Won't the Fed Let Free Markets Do Their Job?

Tuesday’s big financial markets news was the announcement by the Fed that it was going to allow securities dealers to use mortgage securities as collateral to borrow government bonds. The goals of this action by the Fed are to inject more liquidity into the mortgage securities market, put downwards pressure on mortgage rates and ease the credit crunch. In response to this action, the Dow soared by 400 points and the share prices of various financial firms enjoyed significant gains on the day.

To be honest I almost didn’t believe the announcement at first, because it just seemed like a sneaky way to allow the brokerage firms to borrow from the Fed.

In my opinion, the Fed’ actions (and those that celebrate them) are indicative of the attitude that the role of the Fed should be to bail out the financial markets from their mistakes, regardless of the future impact/cost of these actions. Furthermore, one day market gains aside, I’m simply not convinced that the “securities swap meet” will provide long-term value or even address the problems at hand.

1. If you want to solve a problem you have to address the underlying cause, and the Fed’s “securities swap” does nothing to address the underlying causes of: falling housing prices, mortgage defaults and investors/firms/funds, et al forced into fire sales of mortgage securities.
2. While there is a lot of fear around mortgage securities that in “some cases” is artificially deflating their value, it doesn’t change the fact that a lot of these securities are backed by crap mortgages, foreclosed homes, or mortgages that will go into default in the near future. I.e. even if you could erase the invalid fears around mortgage securities, investors would still have great reasons for avoiding them or wanting to pay lower prices. The role of the Fed shouldn’t be to be to provide investors with the confidence to put their money into shaky securities.
3. Since the plan only covers a small % of the mortgage securities its potential impact is rather limited, especially since by focusing on mortgage GSE and Triple A securities it won’t have much impact on the mortgage securities that worry investors most.
4. Does “Triple A” mean anything anymore when it comes to mortgage securities? The underlying assumptions behind the ratings are so flawed (housing prices rising in perpetuity, CDOs = no risk), that I don’t understand why anyone takes the ratings seriously anymore. The mortgage GSEs are on rather shaky ground as well, so their mortgage securities aren’t exactly bullet proof either.
5. It’s a stealth tax-payer bailout of the brokerage firms, or as Jim Rogers calls it: “Socialism for the Rich”.
6. Fed intervention always has a cost, what will be the cost of these actions?
7. Am I the only one who doesn’t see the value in letting the recession run its course, clear out the dead weight and force people to change their behavior?
8. A friend of mine (who we’ll call Jest) described it as such: “I swap my ’07 Lexus for your ’87 Toyota Tercel, then buy back the Lexus and am stuck with the Tercel, you get a magical $40k for doing nothing”. An apt description to be sure.
9. I liken the plan more to throwing a Hail Mary pass not to your best WR, but to an offensive lineman… in the first quarter.

I suspect the market will absorb the plan within days and mortgage rates will be either unchanged or will be creeping upwards again within a week or two. The most important aspect of the plan isn’t the specific actions the Fed took Tuesday, but the fact that it shows that the Fed is willing to do almost anything to bail out the financial sector. I’m less concerned about this plan and more concerned about what they’ll do next; building on point #2 from the above, I’m concerned about the Fed stepping in to guarantee bad securities, mortgages, etc, instead of letting the Free Markets do their job. I think Tuesday could be the first step down a slippery slope to a sort of “de-facto socialism” for the financial markets, the consequences of which will be quite dire to say the least.

In short, we may see benefits over the next three months, 2 years or even 5 years from the Fed’s (arguably extreme) interventionist activities, but what happens after that when the bill comes due? That’s what concerns me right now.

Comments

[the finalhorseman]

one thing i keep noticing: no one looks at the condition (the actual physical condition---the condition upon which a real estate appraisal value is based). some of these homes are gutted. no wiring, no plumbling, no fixtures, no marble counter tops...NADA..ZILCH...Z... uh folks....methinks said and aforementioned properties are worth a BUNCH less then the books show.

i know relatively nothing about high finance...but i do know building supplies are not cheap. so...given )house value in a ledger)-(union labor costs + supply costs ) means the property is worth a ton less then the ledger value says it is. multiply this by 1000 000 homes...and tears + blood + pain start oozing out of lenders vaults.

anyone have comments...if so, please tell me where i made the math error.

[clue me in]

Who benefits from the Fed's intervention? The Fed can not buy confidence so this type of intervention makes headlines but is short lived. It appears that their attention should be on strengthening the dollar not enhancing liquidity. Ah, perhaps that would be just another headline.

[alpha-reader]

Looking around town, Real estate offices are closing/consolidating, just like the mortgage brokers. Title companies, appraisers are or will be affected. The layoffs in the Wall street type jobs haven't really been taken into account.

I see the chain of events just starting - many of these well paying jobs likely represents a family with a good credit rating that may fall. Their ability to pay their "good credit" mortgages will also be affected..... How far will the train run downhill? When will it stop?

[bob f.]

Had the fed allowed Bear to fail it would have had a HUGE neg. affect on EVERYONE, not just the rich. The fed bailed out the middle class with this move. I am against fed intervention 98% of the time but because as a nation we are in unchartered financial waters. Had Bear been allowed to declare bankrup. it would have been a devistating blow to our already beaten economy. What they did was show firms and the public that they will do whatever it takes to get us thru this and that is assuring co.'s who would have laid off or fired 100's of thousands of workers, causing the housing crisis to get even worse.