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 (NYSE: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 (NYSE:C), Blackstone (NYSE: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.