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Federal Reserve Throwing Everything at the Credit Crisis

Interest-Rates / Credit Crisis 2008 Mar 14, 2008 - 10:36 AM GMT

By: Money_and_Markets

Interest-Rates

Best Financial Markets Analysis ArticleMike Larson writes: Feds Flying by the Seat of their Pants- Is it just me, or do the Feds seem to be flying by the seat of their pants?

Is it just me, or was Washington completely blind sided by the magnitude of this housing and mortgage crisis ... and now, they're trying desperately to play catch up?


Is it just me, or has it still not dawned on policymakers that there is no magic policy bullet ... no panacea ... no easy way out of this crisis?

And lastly, is it just me, or is the real fear — the one few of us want to talk about, but can't help thinking deep down — that we have essentially become a new version of 1990s-era Japan. That country saw dual asset bubbles — in stocks and real estate — pop back in the early 1990s. It took the country an entire "Lost Decade" to recover. And some would argue that Japan is still trying to get over the deflationary pain of that era today.

I sure hope that's not where we're heading. But boy, do I worry. Here's why ...

The Federal Reserve Is Throwing Everything at this Crisis ...

The Federal Reserve's reaction to the mortgage crisis started with a discount rate cut in August — 50 basis points. That was followed by another 50-point cut in September ... a 25-point cut in October ... another 25 in December ... a whopper 75-point cut on January 22 ... then another 50 eight days later.

During that same time period, the federal funds rate was slashed from 5.25% to the current 3%. And by all indications, we'll see another 50-point or 75-point cut into the 2s at the Fed's March 18 gathering.

The Fed is slashing rates and throwing hundreds of billions of dollars at the credit crisis.
The Fed is slashing rates and throwing hundreds of billions of dollars at the credit crisis.

But that's not all. In mid-December, the Fed unveiled an unconventional "Term Auction Facility" (TAF) for the first time. The supposedly-temporary plan allows for the periodic auction of funds to depository institutions in exchange for a wide variety of collateral.

The Fed is willing to accept everything at the TAF — from U.S. Treasuries to foreign government debt to commercial mortgage-backed securities, residential mortgages, and even consumer loans (credit cards, auto loans, etc.). Each asset gets a "haircut" depending on the risk involved.

These auctions started at $20 billion each. That jumped to $30 billion a pop in January. Then a few days ago, the Fed boosted the auction sizes to $50 billion!

And the Fed wasn't finished. It also said it would conduct several repurchase transactions totaling roughly $100 billion. Repurchase operations are those where the Fed swaps cash for assets. It's doing them on a 28-day basis, too, rather than the customary overnight term.

To top it all off, the Fed reached into its bag of tricks to come up with yet another plan — the TSLF, or "Term Securities Lending Facility." The TSLF will allow major Wall Street firms and banks that trade directly with the Fed to conduct up to $200 billion in fresh transactions.

They'll be permitted to swap their less-liquid, somewhat impaired mortgage-backed securities and Fannie Mae and Freddie Mac debt for highly liquid, rock-solid U.S. Treasuries. The assumption is that this will help ease pressure on balance sheets and help reduce mortgage rates.

I don't know about you, but I'm having a very hard time keeping up with all these acronyms and all these "solutions." Moreover, it's not just the Fed that has shifted into action ...

The Legislative and Executive Branches Are Moving into Major Rescue Mode, Too

The "FHASecure" plan was one of the first major offers unveiled in August. The idea there was to make it so borrowers with high-risk private mortgages could refinance into government-insured FHA loans.

Soon thereafter, we heard about the "Paulson plan" to freeze adjustments on certain subprime adjustable rate mortgages.

And we learned the government had put together a "HOPE NOW" alliance of top mortgage lenders and servicers that would try to come up with ways to help stressed borrowers.

Then in February, it was time for "Project Lifeline" — a plan to postpone foreclosures for 30 days for certain borrowers. During that time, their servicers would be obliged to hammer out loan modification or workout plans.

House Financial Services Committee Chairman Barney Frank is introducing anti-foreclosure legislation.
House Financial Services Committee Chairman Barney Frank is introducing anti-foreclosure legislation.

The economic stimulus package that is getting refund checks mailed out to most U.S. citizens also included some mortgage-related provisions. They allow Fannie Mae, Freddie Mac, and FHA to buy or insure larger loans — an attempt to loosen up the market for "jumbo" mortgages.

Over in Congress, House Financial Services Committee Chairman Barney Frank is introducing anti-foreclosure legislation. States would get $10 billion to buy foreclosed homes. Mortgage servicers would also be encouraged to write down the value of outstanding loans. Then, the borrowers would be refinanced into government-insured FHA mortgages.

Finally, policymakers are unveiling a list of reforms designed to prevent future crises in the mortgage industry:

  • Nationwide licensing of mortgage brokers will be implemented.

  • Credit ratings firms will be required to update their ratings scales to distinguish between "structured" products (that would be CDOs and other complex debt) and traditional bonds. They'll also have to disclose conflicts of interest.
  • And other proposals will affect how loans are bundled and packaged into bonds for sale to investment firms.

But you know what?

All the King's Horses and All the King's Men Can't Seem to Put the Market Back Together Again

Despite all the government intervention ... and artificial monetary stimulus ... when you look around, not much has changed.

We're still awash in millions of excess homes ...

We're still witnessing the sharpest home price declines in decades ...

We're still seeing hedge fund implosions ... mortgage company meltdowns ... and multi-billion dollar write-downs almost every day.

Just this week, a mortgage bond fund run by the high-powered private equity firm Carlyle Capital essentially collapsed. The fund couldn't meet more than $400 million in margin calls from its lenders, forcing it to default on a whopping $16.6 billion in debt.

Bloomberg puts the total count of losses and write-downs related to the mortgage crisis at $188 billion ... and counting.

And that just underscores a fundamental point I've been making for a long time ...

The only way to prevent the pain of popping bubbles is to prevent bubbles from inflating in the first place!

You see, the Federal Reserve have this asinine policy of ignoring asset bubbles as they inflate. Policymakers claim that's because they shouldn't substitute their judgment for the market's, and that it's impossible to identify bubbles except in hindsight anyway.

The better solution — in their view — is to come in and try to mop up the aftermath by slashing rates and taking other steps.

But that's just nuts!

I mean, if you asked 100 people on the street whether dot-com stocks were experiencing a massive bubble in 1999, you'd have heard 99 answer yes.

And if you asked another 100 people whether the housing market was a massive bubble in 2004 and 2005, you'd get the same thing: A resounding yes from just about everyone.

You could see it in the statistics. You could see it all around you in everyday life — the Miami condo parties, the buyers camping out to snap up three, four, or five homes at a time, the 5%-every-quarter price increases in homes. Respectable economists and analysts everywhere were warning that we were courting disaster.

The idea that the Fed couldn't identify that we were in a bubble — one that called for aggressive regulatory and monetary policy action to counter it — is patently ridiculous.

So here we are: Stuck in a real estate down cycle that's more severe than anything we've had to face in decades.

I want to believe we can turn things around. I want to believe that all these policy actions ... the aggressive construction cutbacks we're seeing from the major home builders ... lower home prices ... lower interest rates ... and everything else will help turn the tide. And I still think that can happen as we head into 2009 and beyond (I'm writing off 2008).

But I have to tell you, it's hard to eliminate that nagging voice in the back of my mind — the one that says we're heading for the same thing that happened to Japan in the 1990s.

Keep your fingers crossed and hope for the best. But also continue to take steps to prepare yourself for the reality of today's painful slump. In my book, that means keeping a large reservoir of cash on hand ... keeping money in contra-dollar investments like gold and foreign bonds ... and by all means, avoiding excessive debt.

Until next time,

Mike

This investment news is brought to you by Money and Markets . Money and Markets is a free daily investment newsletter from Martin D. Weiss and Weiss Research analysts offering the latest investing news and financial insights for the stock market, including tips and advice on investing in gold, energy and oil. Dr. Weiss is a leader in the fields of investing, interest rates, financial safety and economic forecasting. To view archives or subscribe, visit http://www.moneyandmarkets.com .

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