Wednesday, 3 December 2008

Some good news for investors in mortgage bonds – and for the rest of us

Under some hype, the US Federal Reserve announced an extra $800bn facility, which was allegedly being "pumped" into the markets. This new initiative as not passed by congress for the rather simple reason that this was a conceptually simple extension of Fed's normal lending facilities. Yet another letter combination joined the fray, the TALF , short for Term Asset-Backed Securities Loan Facility, which will lend up to $200 billion to holders of AAA-rated ABS backed by newly and recently originated consumer and small business loans. The Fed also will purchase up to $100 billion in debt from the Fannie Mae and Freddie Mac, and up to $500 billion in GSE-backed mortgage-backed bonds.

At the same time it has been visible in the market that Federal Reserve is buying Treasury bonds all along the yield curve. Fed Chairman Ben Bernanke has even stated that Fed has "obviously limited" room for lowering short term interest rates further and that other, less used policies, may be used. Such as buying Treasury bonds.

There are several implications of these moves. Most importantly, the conjunction of the two indicates that Fed is acting very actively in order to make sure that the T-bond yield curve keeps flattening, and secondly, that the huge risk premium in the mortgage segment will be forced down. The reason is that the US government is under heavy pressure to "do something" about the slowly unfolding disaster going on in the US mortgage market. One of the elements of "doing something" is to create conditions under which some homeowners now under pressure from high refinancing rates in the short end of the market can be offered a debt restructuring to a less volatile segment of the market and thereby lower their financing rates significantly. Federal Reserve is working to create the background for a "bail-out" of home-owners. Of course the concrete form of that will be determined by the new Administration in the US.

Overall that $500bn in the TALF would be enough to purchase more than half of all new issues in the GSE backed mortgage segment, and hence enough to take a lot of the troubled assets out of the market. It appears that finally the cornerstone is being laid for switching into mortgage bonds instead of treasuries: falling T-bond yields along the curve PLUS a narrowing spread. This is likely to spread all over the world, were mortgage spreads have remained stubbornly high, despite lack of convincing signs that conditions are just half as bad as in the US.

But the more important message is that by buying bonds along the T-bond yield curve, Fed is simply monetising (part of) the government deficit. Printing money and pouring it directly into the economy instead of putting money into the banking system which remains frozen, anyway. For more than 30 years it has been the credo of all responsible economists that central banks should not monetise the debt of the public sector, but doing so right now is a definite step in the right direction. It means that the dysfunctional banking system is partly bypassed and fresh money is handed down where it is needed, primarily to the mortgage lenders.

In the good old days – some months ago – this would have been considered sacrilege and likened to putting out the inflationary fire with kerosene. Now, with inflation plummeting and the d-word back in fashion again, printing money is not any longer one of the seven deadly sins of a central banker. Deflation is still far away, but dis-inflation is certainly back. So now there is leeway to increase the monetary stimulus. Fed Chief Ben Bernanke was ridiculed in 2002 for suggesting that printing money in a recession might help if everything else failed. He was even nicknamed Helicopter Ben because the economists' standard parable is to throw money down from a helicopter.

Pretty much everything else has failed, and with increasing paralysis of policymakers in the dying days of the Bush Administration, the Fed has made a very significant move in the right direction.

Whether it is enough, is still an open question. Remember that the next segment in the US mortgage market to have massive resets of the introductory "teaser rates" is the "Alt-A", one notch up from the "Sub-Prime". They will have massive resets in March and April 2009. Maybe a plan will be in place to help them avoid a wave of foreclosures. Maybe not. The stock market appears convinced that the latter is the case.

Oh yes, and if you have exposure to dollar assets, here is a small teaser - of a different nature. If US short term interest rates are on their way towards zero, and if Fed is printing money - what will happen to the dollar?

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