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Dream Bailout Has a Dark Side 2009/04/03

Filed under: U.S macro economy,US REAL ECONOMY — rogerwang2046 @ 01:45

It will go down as one of the biggest – and most popular — bailouts of the credit crunch. But who will pay for it later?

The Federal Reserve is buying hundreds of billions of dollars of cheap mortgages from Fannie Mae and Freddie Mac. The purchases, which so far amount to $250 billion and could grow to $1.25 trillion, has driven mortgage rates to historical lows, inducing house purchases and sparking a refinancing wave.

This serves key social and political goals: It helps shore up house prices, while the lower rates put extra money into the pockets of people who aren’t struggling to service their mortgages. This makes them less likely to oppose taxpayer funded moves to support homeowners facing foreclosure.

What’s more, banks holding Fannie and Freddie securities get to book big gains as the Fed’s buying spree drives up prices. Analyst Meredith Whitney estimates the top ten banks increased their holdings of securities issued by Fannie and Freddie and other government agencies by $128.6 billion, or 30%, in the fourth quarter. Those will be marked higher in the first quarter.

Most convenient of all: This mortgage buying is being done by the Fed, which doesn’t need approval from Congress for the purchases.

[Federal Reserve]Getty Images

The Federal Reserve has taken dramatic steps to revive the economy and stabilize the financial system.

On paper, it’s a dream bailout. It benefits not just large banks but also ordinary people, it’s hard for politicians to tamper with, and the Fed doesn’t have to borrow money to fund the purchases — it just prints it instead.

When something’s this good to be true, it pays for investors to dig deeper. And the risks abound.

The biggest is that the purchases will deal another blow to the credibility of the Fed, whose monetary policies helped stoke the credit boom.

Of course, printing money carries inflation risk. And the Fed’s aggressive actions mess with market pricing. The mortgage purchases could help increase assets on the Fed’s balance sheet to $3 trillion – equivalent to over 20% of GDP. So when it stops buying, mortgage rates could rise sharply.

The size of the Fed purchases are already overwhelming private markets. Right now, there is limited investor demand for Fannie and Freddie mortgages with coupons under 5% due to the risks of holding such low-yielding paper. Filling that gap, the Fed purchased $192 billion of 4% and 4.5% conforming mortgages, on a gross basis, in the four weeks ending March 25.

Holding this risky paper could damage the Fed later on. If it wants to sell 4% mortgages to private investors, it would likely have to do so at a price that creates a yield above 5% — potentially triggering a loss for the Fed. It could of course choose to hold the mortgages to maturity, with any credit losses covered by Fannie and Freddie. But since the Treasury is committed to backing those two, the taxpayer could yet end up covering additional Fannie and Freddie losses that result from pricing mortgages too low.

The mortgage buying could also alter the Fed’s core mission in a detrimental way. In an unusual joint statement last month, the Fed and Treasury said the Fed’s job was not to “allocate credit to narrowly-defined sectors or classes of borrowers.” Yet focusing so much money on residential mortgages, and thus homeowners, seems to do just that. Investors might come to expect support purchases every time an asset gets into trouble.

Finally, the Fed’s actions may attract Congressional scrutiny. “Everything’s fine as long the Fed is making perfect decisions,” says Rep. Scott Garrett. “The challenge for Congress is: can we do anything to create oversight to address that.”

This bailout may not stay back-door for long.



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