It’s amazing what big money will do. With the announcement by the Federal Reserve that it will loan $200 billion to 20 leading financial institutions, the Dow Jones Industrial Average shot up 416.66 points in just one day — a performance not seen since 2002.
While $200 billion is a lot of money, the really remarkable part of the story is the willingness of the Federal Reserve to accept a new and unusual form of security for the loans: “non-agency AAA/Aaa-rated private-label residential MBS.”
In plain language the Federal Reserve is allowing Wall Street to borrow $200 billion, loans secured by mortgage-backed securities. Given that the market for mortgage-backed securities is at the heart of the current credit crunch, this is a huge favor, the equivalent of securing a $50,000 auto loan with a rusted clunker.
The Fed, according to the Wall Street Journal, will “lend Wall Street as much as $200 billion from the central bank’s own trove of sought-after Treasury bonds and bills for 28 days in exchange for a roughly equivalent amount of mortgage-backed securities, including some that can’t ordinarily be used in transactions with the Fed. Uncertainties about the value of the underlying mortgages, plus forced selling by some investors to repay broker loans, have led many investors to spurn these securities, making them especially difficult to trade.
“By taking some of these securities on its own books, the Fed is seeking to make its primary dealers — the network of 20 Wall Street firms with which it typically does securities business — more comfortable buying them from their own clients. It hopes this could lead to higher prices and thus lower yields on the mortgage-linked debt. A decline in those yields could help banks offer lower interest rates to prospective homebuyers.”
“So basically the Fed is going to be swapping Treasuries for dubious securities, in an attempt to give the market a REALLY BIG slap in the face,” says Paul Krugman, an op-ed columnist with the New York Times and a professor of economics and international affairs at Princeton.
What we have here is a bailout. The Fed is creating a market for securities that have been tough to sell at full value. If loans are not repaid and the Fed takes title to the mortgage-backed securities pledged as collateral, then it’s effectively acting as buyer, trading $200 billion in good securities for weak securities worth far less.
The practical reality is that the Fed’s 20 best friends can now hedge their bets. If the value of mortgage-backed securities go up investors can repay the $200 billion. If values go down, the Fed can repeatedly renew the loans for another 28 days, thus assuring that top-20 borrowers need not default on their obligations. Think of it as a loan modification.
For months there has been talk in Washington about avoiding the “moral hazard,” an expression which means that using government dollars to help those now in trouble might not be a good idea. Why? Because helping homebuyers who financed with toxic loans or real estate investors who are now stuck with upside-down properties might encourage them to repeat their behavior.
Plainly folks on Wall Street are nothing but investors and a lot of them made losing investment decisions. Some may also have engaged in fraud; there are ongoing reports that the FBI is busily investigating a number of mortgage-related firms. Somehow, though, concerns about a “moral hazard” don’t seem to apply when the numbers at risk are millions and billions.
The $200 billion Fed loan raises several thoughts:
First, mortgage-backed securities have now been divided into two groups — those which can effectively be “sold” by defaulting on Fed loans and those which cannot. Without access to the Fed’s loans, are the mortgage-backed securities held by investors outside the big 20 primary dealers suddenly more risky? If that’s the case it could mean many investors will want more interest.
Second, are the Fed moves related to stock values? The August rate cut occurred a few days after the Dow dropped below 13,000 while the March action happened after the Dow fell below 12,000. Are the Fed’s actions designed to directly support the stock market? If yes, what happens if the Dow again drops below 12,000? Or 11,000? Just how many financial arrows are left in the Fed’s quiver?
Third, what happens if inflation becomes a problem? Consumers now face rising gas and food prices, the job base is contracting, the federal deficit is likely to exceed $400 billion this year, the value of the dollar continues to fall and many local real estate markets have surplus inventory as a result of historically-high foreclosure levels. In such an environment the Fed is largely stuck — if it lowers the discount and federal funds rates it encourages inflation, if it raises rates it increases short-term borrowing costs, including the interest rates for many home-equity loans. Whether it can create additional loans for primary dealers without setting off political alarms is not clear.
“We’ll need to wait until later in the Spring to see what results are produced by the Fed’s $200 billion loan program,” says James J. Saccacio, chief executive officer at RealtyTrac.com, the nation’s leading source for foreclosure data. “In the best case the market will be re-assured, stock indexes will rise and lenders will liberalize mortgage standards so that more people will be able to refinance into better loans and lower rates. That way the benefits of the Fed move would be shared by everyone.”
Peter G. Miller is the author of the Common-Sense Mortgage and is syndicated in more than 100 newspapers.