5 Reasons the Fed's Credit Bailout Will Likely Disappoint

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Includes: DIA, IEF, SPY
by: Matt Blackman

While stock traders began to party again after hearing news of the Fed March 12 credit bailout, currency traders were betting it wouldn't work. After staging a brief rally on Tuesday, the US dollar fell to a new all-time low against the euro Wednesday as confidence that the Fed move would solve the credit crisis and economic fallout proved short-lived.

Hopes have run high that the $250 bailout would prove the requisite panacea by stock investors prompting many to call a bottom in stocks. But here are five reasons why they will probably be disappointed.

1) Much more subprime pain to come - According to a Bloomberg article from March 11,

Even after downgrading almost 10,000 subprime-mortgage bonds, Standard & Poor's and Moody's Investors Service haven't cut the ones that matter most: AAA securities that are the mainstays of bank and insurance company investments. None of the 80 AAA securities in ABX indexes that track subprime bonds meet the criteria S&P had even before it toughened ratings standards in February, according to data compiled by Bloomberg. A bond sold by Deutsche Bank AG in May 2006 is AAA at both companies even though 43 percent of the underlying mortgages are delinquent.

Sticking to the rules would strip at least $120 billion in bonds of their AAA status, extending the pain of a mortgage crisis that's triggered $188 billion in writedowns for the world's largest financial firms. AAA debt fell as low as 61 cents on the dollar after record home foreclosures and a decline to AA may push the value of the debt to 26 cents, according to Credit Suisse Group. "The fact that they've kept those ratings where they are is laughable," said Kyle Bass, chief executive officer of Hayman Capital Partners, a Dallas-based hedge fund that made $500 million last year betting lower-rated subprime-mortgage bonds would decline in value. "Downgrades of AAA and AA bonds are imminent, and they're going to be significant."

So what happens to the Fed requirement that any collateral exchanged for Treasuries not be subject to a downgrade? According to the article, all but six of the 80 AAA ABX subprime bonds failed an S&P test for investment grade status. As I understand the program, they should NOT qualify for the Fed collateral exchange.

2) Home price declines are still accelerating. This means that bonds that qualify as investment grade today have a better than 50-50 chance of not qualifying tomorrow. Rating agencies essentially discounted the probability of housing price declines. How can the Fed (and taxpayers who risk picking up the tab) trust them now?

3) The Fed bailout allows that mortgage bonds be used as collateral for a 28 day period. What happens when the 28 day period elapses? The Fed has also said it would discount the value of bond collateral. By how much? Do banks get to discount them again before taking them back after the 28 day period has elapsed? I trust that the Fed has no plans to be the buyer of final resort for this junk. It would mean this liability would ultimately be passed on to the taxpayer. But even giving Bernanke & Co the benefit of the doubt, this solution is very short-term in scope. And what happens when its over and $200 billion in bonds have been exchanged?

4) The current housing (and credit) bubbles took years to form and were powered by the creation of trillions in derivatives. The credit default swap market alone doubled every in 2006 and 2007 and at latest count had grown to more than $40 trillion. The chances that any bailout attempts by government or quasi government agency like the Fed will re-inflate these bubbles are effectively zero. The latest estimate by Friedman, Billings and Ramsey is that the $11 trillion mortgage market needs about $1 trillion in new investment to halt the slide in bond prices that began last year. But that estimate assumes that payments on more than 90% of US mortgages will remain current - Is this realistic assumption given the scope of home price declines and the amount of zero down, no doc, lier mortgages etc. that were issued? Probably not. What motivation do those who made little or now down payment have to maintain their payments on a home that has dropped below the mortgage amount?

5) Can this bailout halt the economic slide that my indicators are telling me will result in a recession? (see this post) Can they reverse the economic cycle? Certainly not on both counts if history is any guide. More likely, the latest stock run is nothing more than a predictable bear market rally that will quickly evaporate, just like those that resulted from past bailout hopes have done since November. As Joseph Mason commented in a Bloomberg interview March 12, all Fed efforts so far have focused on providing liquidity but they do nothing to address credit losses. Someone has to take those losses including homeowners, consumers as well as banks, lenders, hedge funds etc. And those losses are far from over. And so far, the only credit problems being discussed are mortgage related. What about commercial, car, student, credit card, M&A, LBO and other loan markets? What happens when they begin to blow up?

Disclosure: None