Did the Fed and GSEs Avert a Crisis?

The steps taken to alleviate the conditions in the mortgage markets by the Federal Reserve – the Fed using its balance sheet to take mortgages from banks and helping finance the takeunder of Bear Stearns (BSC) - are positive in for the near-term. But now, the Fed has $430 billion of exposure to the mortgage market, roughly half of its entire balance sheet.

The facilities offered by the Fed are meant as temporary and designed to alleviate the stress in the mortgage market. The terms are not long – 28 days – and the securities are expected to be put back to the banks and the dealers. But the premise of the Fed’s new-found position is that things will get better and not worse.

Indeed, things are getting better as spreads narrow over the past few days, but the fixed income markets have oscillated between improving and deteriorating for nearly a year now, with each downdraft worse than before. If in a few months from now, it gets worse again, will the Fed take on $600 billion in mortgages or maybe its entire balance sheet of $866 billion? And then what would they do if things become worse still, print money and buy T-bills to swap for even more mortgages and CDOs?

The futures market is expecting the Fed to cut the funds target to 1.5%-1.75% by summer. If the cyclical pressure does not begin to abate, the more the Fed uses its balance sheet and cuts rates, the more the central bank is pushing on the proverbial string.

It is not only the Fed that is attempting to prop up the housing market. On Wednesday, OFHEO stated that the required capital surplus for Fannie Mae (FNM) and Freddie Mac (FRE) will decline from 30% to 20%. This should immediately free up $200-$300 billion for the Government-Sponsored Enterprises [GSEs] to buy mortgages. However, like the Fed taking on more risk to bail out the mortgage market, the GSEs will do the same, increasing the amount of mortgages they will hold for each dollar of capital on its books.

Contrary to the GSEs supporting more mortgages with its current capital base, one solution for banks is to raise more equity or build retained earnings by cutting the dividend. But, as UBS pointed out in a recent piece, banks are not raising share capital. Instead, banks are issuing preferreds and hybrids, a lower form of equity. Most of them are not cutting their dividends either.

(As a side note, surely sovereign wealth funds will be more wary committing fresh capital buying securities of financial companies, given how their money has vaporized in investments such as Citigroup (C), Blackstone (BX), and of course, Bear Stearns.)

The fundamental problem is declining housing prices. As long as housing prices continue to decline, there will be more problems in the credit markets. To stop the problems in the fixed income markets, housing prices must stop going down.

Problems in the housing market began as unheard of prices, exacerbated by lax lending standards and easy money for mortgages, fell on its own weight. Now, housing prices are only just beginning to feel the brunt of the economic slowdown. Unemployment is rising, the economy is either slowing or in recession, and firms are growing more cautious. It is difficult to imagine this is the bottom of the housing market now. The CEO of Freddie Mac recently said that the decline in home prices is only one-third finished.

Home prices peaked out in the summer of 2006. In a country where house prices rose for six decades, it may appear that a bear market in housing lasting almost two years is getting long in the tooth. However, real estate prices in Japan fell for 15 years - two years is nothing.

Yes, yes, I know America is not Japan. But dismissing the Japanese analogy outright is as specious as accepting the argument that housing prices cannot fall because they had not for over 60 years. Perhaps home prices in this country will not fall for 15 years, but why not three or five or seven years? This is not a prediction but to dismiss a long decline out of hand because one cannot fathom the prospect is not a strong cognitive thought process.

The two initiatives by the Fed and the GSEs may very well be the nadir in the market. However, for it to be so, the market must believe there is enough equity in the system to support the coming write-downs and home prices must stop falling. If not, then the systematic risks will rise remarkably as the Fed and the government will have fewer options and less credibility to deal with the problems in the financial markets and in the economy.

Comments

[MattBlackman]

And the chances that home prices will stop falling anytime soon is pure fantasy. Even OFEHO CEO Dick Syron believes that home price declines are "only one-third done," which is interesting considering how behind the curve that agency has been through the housing mess. Take a look at this chart of inflation adjusted home prices and tell me home prices will level off anytime soon... tradesystemguru.com/co...

[redriver]

The nadir or lowest point of the housing market would be the point at which you can identify support. Here in Phoenix that point is 2001. The city was thriving/growing, housing was affordable 2.6 on the Harvard (AI) affordability index. AI = median home price/median household income. Now its 4.8 (actually went up in 2007). That's the same AI as Santa Barbara! Does anyone really believe that making Phoenix as expensive as Santa Barbara is a good business decision?
So, not being a "economist", it would seem we have a ways to fall before "the market/the buyers" come back out and buy. The current median home price is around $242,000 and the current median household income (citydata) is $61,863. So 61,863 X 2.6 is $160,843 or, a 34% decline needed to get back to balance.
Obviously the more propping up we do, the longer it will take the market to fix itself. The ramp of pain will just keep getting longer. Having just read The Forgotten Man and just seen the Fed Lending Graph I am not at all comforted by any of these moves. Lynch said it best, Mr. Market doesn't care about you, doesn't know your name. Probably doesn't care about how much equity we have lost or, how safe our families are now. That was our job.
But then again, I'm not an economist. Not a buyer either.

[Tony Soprano]

Since there is so much angst directed toward the Fed and the US Government, I decided to listed some events, not all of them, that had dramatic ramifications on lives, cost and the psychology of our country. I started in 1906 because it’s just a little over a hundred years. As I compiled the list, I could not help but feel the great sacrifices that many American’s have made and what a resilient country, economy and government we have in American.

The 1906 San Francisco Earthquake and fire, registered 8.25 on the Richter scale; estimates range from 700 to 3,000 dead or missing, approximately 225,000 injuries and $400,000,000 in 1906 dollars.

Recession, May 1907-June 1908, 13 mo

Recession Jan. 1910-Jan. 1912, 24 months

Completion of the Panama Canal, 1914 – 27,500 workers are estimated to have died

Recession Jan. 1913-Dec. 1914 23 months

World War I -- 116,708 killed – 33 billion

Spanish influenza, 1918, killed over 500,000 people in the worst single U.S. epidemic.

Recession Aug. 1918-March 1919 7 months

Recession Jan. 1920-July 1921, 18 months

Recession May 1923-July 1924 14 months

Recession Oct. 1926-Nov. 1927 13 months

The Great Mississippi Flood of 1927, flooded 27,000 square miles, 246 killed

The Great Depression, Black Tuesday, crop prices fell by 40 to 60 percent, after the panic of 1929, and during the first 10 months of 1930, 744 US banks failed. (In all, 9,000 banks failed during the 1930s). By 1933, depositors had lost $140 billion in deposits.

The Dirty Thirties, longest drought of 20th century. Peak periods were 1930, 1934, 1936, 1939, and 1940. The "dust bowl" covered 50 million acres in the south-central plains during the winter of 1935-1936.

Labor Day Hurricane of 1935, 400 killed

Recession May 1937-June 1938 13 months

World War II – 408,306 killed – 360 billion

Wartime Controls: 1941-1945 rationed consumer items ranging from sugar to gasoline

Recession Feb. 1945-Oct. 1945 8 months

The Marshall Plan, July 1947 – 13 billion in economic and technical assistance were given to help the recovery of the European countries

Recession Nov. 1948-Oct. 1949 11 months

Korean War, July 1951 - July 1953 – 33,000 killed in action

Recession July 1953-May 1954 10 months

Recession Aug. 1957-April 1958 8 months

Recession April 1960-Feb. 1961 10 months

The Cold War, some estimates shows $8 trillion was spent, worldwide, on nuclear and other weapons between 1945 and 1996

The Cuban Missile Crisis, Oct. 1962

Good Friday Earthquake (1964) In Alaska, it was the fourth biggest earthquake recorded

Vietnam War, 1963 – 47,378 killed in action

The murder of JFK, 1963 Nov

The Gulf of Tonkin Incident, Aug 1964

The murder of Dr King, April 1968 and Bobby Kennedy, June 1968

The city riots of April, 1968 – 30 cities affected

Hurricane Camille, Aug 1969, 259 killed

Recession Dec. 1969-Nov. 1970 11 months

Stagflation of the 1970s began

Nixon first imposed wage and price controls on August 15, 1971

Oil Embargo, Oct 1973 long gas lines

Recession Nov. 1973-March 1975 16 months

Articles of Impeachment of Nixon started
(Approved by a vote of 27-11 by the House Judiciary Committee on Saturday, July 27, 1974.)

Deregulation: 1974-1992 this era began when Nixon left office

Three Mile Island nuclear power plant crisis, March 1979

Mount St. Helens eruption 1980

Recession Jan. 1980-July 1980 6 months

Prime reached unbelievable 20% in January 1981,

AIDS was first reported June 5, 1981 by the government – It is thought that more than one million people are living with HIV in the USA and that more than half a million have died after developing AIDS.

Recession July 1981-Nov. 1982 16 months

California earthquake 1983

The 87 market crash - Black Monday

California earthquake, 1989

Recession July 1990-March 1991 8 months

Iraq invaded Kuwait on August 2, 1990

The Persian Gulf War, 1991 or Desert Storm Jan 1991

Hurricane Andrew 1992 very destructive United States hurricane

The Great USA Flood of 1993

Intervention in the Former Yugoslavia,

Dot Com Bubble, climaxed on March 10th, 2000 with the NASDAQ peaking at 5132.52

9/11 Attack, 2,974 people died

Recession March 2001-Nov. 2001 8 months, Airline Industry Collapsed

Enron bankruptcy in late 2001, employed 22,000

WorldCom, July 21, 2002, filed for Chapter 11

Iraq War, March 19, 2003 – 4,000 dead

Hurricane Katrina, late August 2005, 1,836 people lost their lives

Start of the Great Housing Recession or Sub-prime Recession 2006 or 07, 08? Date to be determined.

[jcrash]

I bought my house here in Tulsa about 5 years ago. 3100 sq. ft. Custom home. Today, it is worth approximately what I paid for it (plus a few percent at most, I'd guess).

No appreciation = no depreciation. I'm sure much of the nation is like my area.

[vaduz]

the fazit is: the danger is still growing.