The Fed’s latest attempt to ease seized-up credit markets marks its most direct effort yet to repair the mortgage meltdown (and slumping house prices) that poses the biggest threat to the economy.
The Fed’s pledge to lend, in return for mortgage debt, $US200 billion of Treasuries to the securities firms that trade directly with the central bank is the most dramatic move so far.
In effect the Fed is telling the market that for the time being it will accept inferior mortgage backed securities (or mortgages) in return for Triple A rated paper from the US Government.
Officials later briefed reporters that the program may expand as the central bank seeks to break the logjam in the home-loan market.
The step goes beyond past initiatives because the Fed can now inject liquidity without flooding the banking system with cash.
Bernanke and his colleagues are trying to halt what some have called a ‘feedback loop’ where losses on mortgage investments cause banks to cut their lending, sending the economy into a deeper contraction, which then in turn puts more homes on the market, driving prices down, slashing equity and cutting the value of securities, producing more losses, and forcing the banks to again cut lending.
Under the new Term Securities Lending Facility, the Fed will lend around $US100 billion in US Treasury securities for 28-day periods in return for debt including Triple A rated mortgage securities sold by Fannie Mae, Freddie Mac and by banks. The weekly auctions start on March 27.
Unlike the newest tool, the past steps added cash to the banking system, which affects the Fed’s benchmark interest rate. The central bank had to withdraw the funds through operations with securities dealers to keep the rate from falling below the target.
By contrast, the TSLF injects liquidity by lending Treasuries, which doesn’t affect the federal funds rate. That leaves the Fed free to address the mortgage crisis directly without concern about adding more cash to the system than it wants. According to media reports, the Fed has about $US713 billion of Treasuries
What the Fed is doing is trying to make sure the credit creation processes in the US markets, the most powerful in the world, are not frozen by fear and uncertainty that a big financial group could fail.
It’s an attempt to get banks back to lending and to convince the likes of Citigroup to restore the $US45 billion in cuts to its mortgage sales over the next year.
It’s not designed to help the US economy: merely slow its slide into recession, which wouldn’t of itself these days drag the rest of the world into the red.
But a frozen set of US financial markets with no lending or credit creation being generated by the big commercial and investment banks on Wall Street (which have global reach) would be terrible. Even China, with all its hundreds of billions of dollars in foreign reserves and a booming economy, would be badly hurt. After all China is already losing value from those reserves with every drop in the value of the greenback.
Much of money injected into the markets could very well be re-lent back to the US Government to finance its huge and growing budget deficit, which will be boosted from May by the $US162 billion emergency stimulus package, which includes around $US130 billion in tax rebates for individuals.
Think of it as a huge overdraft secured by these Triple A rated mortgages and the US Treasuries: an uneven bargain to be sure, but a sign of just how desperate the Fed is to stop the rot in housing in particular.
The Fed meets next week and will cut its federal funds rate by either 0.75% or 1% to maintain the momentum from the unprecedented series of liquidity boosting measures announced on Friday and on Tuesday.
With major investment banks, Goldman Sachs, Morgan Stanley, Lehman Bros and Bear Stearns (which has been the subject of denied rumours that it is short of liquidity) reporting next week it was going to be an enormous pressure point for US and world markets.
The slightest hint of one of these banking giants having liquidity strains, or questionable accounts and figures, and there could have been a huge sell off, such is the fragility of confidence in the state of the markets in the US and around the world.
The money won’t help underwrite the huge and growing budget deficits of state and local governments across the US which are suffering revenue shortfalls from the housing slump and subprime mess: not to mention losses on investments in Wall Street funds, failed bond issues and other setbacks caused by the credit crunch.
Nor will this money stop these levels of government from sacking thousands of people, nor will it stop thousands more in other industries from losing their jobs.
It won’t lower the debt burden on US consumers who generate 70% of US economic activity these days, nor will it help the millions of people made homeless and now renting or worse because they lost their homes when their subprime mortgages became too expensive and the banks foreclose on their homes.
But it should buy time and it should help convince nervous banks and others in the financial sector panicking about US Government-backed debt (such as Freddie Mac and Fannie Mae bonds), that the Fed and others won’t stand by and watch the whole lot slide into depression
For that’s what is at the end of what is happening in the US and other countries such as Spain, Ireland and Britain where falling property values are tugging the rest of the economy into a black hole.
