Can someone explain this new FED credit plan announced today?

[thefed]

I just dont get it. I think they are saying that they will be buying $200 BILLION worth of loans (presumably the bad ones) from the banks.

In turn.....this does what? Who then will be servicing the loans? I dont get it!!!


im not being sarcastic, i just dont understand


thanks

 

[brewer12345]

They aren't buying anything. They are loaning treasury dealers treasuries and for collateral they are taking AAA mortgage backed bonds issued by Fannie, Freddie, Ginnie and private issuers (Wells Fargo, etc.). Effectively, they are loaning against the safest, cleanest mortgage bonds in existence, many of which already have an explicit or implicit guarantee from the federal government.

 

[ziggy29]

They aren't buying anything. They are loaning treasury dealers treasuries and for collateral they are taking AAA mortgage backed bonds issued by Fannie, Freddie, Ginnie and private issuers (Wells Fargo, etc.). Effectively, they are loaning against the safest, cleanest mortgage bonds in existence, many of which already have an explicit or implicit guarantee from the federal government.

Absolutely correct -- and to add to this, this is important because many of the financials which were melting down were being killed by margin calls. The prices of even these extremely high-quality mortgage securities were falling out of a combination of fear and an excess number of sellers. That triggers margin calls, which forces more selling into a market with no buyers, and you started seeing very good paper getting killed out there. By letting these institutions borrow Treasuries (which aren't suffering the same fate in the market) in place of their currently struggling, less liquid securities, these institutions can stabilize their balance sheets and fend off the margin calls, *hopefully* long enough for these markets to regain some sanity so they can get their original paper back.

That's how I understand it, anyway. This is not a bailout, and especially NOT a bailout of subprime (which is not included in this scheme).

 

[Hamlet]

From the CNN article:

"But in an unusual move, AAA-rated mortgage securities issued by banks will also be accepted. Many investors have shied away from these mortgage-backed securities because they fear defaults in the underlying assets will erode the value."

My understanding is that some of these bank-issued "AAA" securities may not end up being AAA in the end. Still, I think its a good move by the Fed. Right now, everyone is paralyzed by fear. I don't think the bulk of Americans are going to default on their home loans. If they do, it probably won't matter that the Fed got stuck with them, we'll all be ****ed anyway.

This should help liquidity problems that the banks are having. It won't help them if the assets end up being no good.

Bad things may still be ahead (especially for the poorly run banks), but simple fear isn't going to seize up the markets. The banks will be able to function like these securities are really AAA unless they are proven not to be by actual defaults, and not just speculation.

Is my thinking here reasonable brewer, or am I completely off base?

They aren't buying anything. They are loaning treasury dealers treasuries and for collateral they are taking AAA mortgage backed bonds issued by Fannie, Freddie, Ginnie and private issuers (Wells Fargo, etc.). Effectively, they are loaning against the safest, cleanest mortgage bonds in existence, many of which already have an explicit or implicit guarantee from the federal government.

 

[brewer12345]

Sounds reasonable to me, except that I would say that it is highly unlikely that any large amount of prime, AAA rated will be downgraded, let alone actually lose money.

 

[Hamlet]

I'm a little worried about any loans made against real estate in bubble markets. I think some of those could go bad eventually, even if they are pretty clean looking.

30-year fixed loans with 20% down looks pretty clean in general. However, if they was made in 2006 against homes in California, some of them may have very little equity left. If we have a real 70s style recession, there may end up being some principle risk.

This is a fairly unlikely outcome, but since they were issued with almost no risk premium to treasuries, I can understand why no one wants to own them.

Sounds reasonable to me, except that I would say that it is highly unlikely that any large amount of prime, AAA rated will be downgraded, let alone actually lose money.

 

[brewer12345]

30-year fixed loans with 20% down looks pretty clean in general. However, if they was made in 2006 against homes in California, some of them may have very little equity left. If we have a real 70s style recession, there may end up being some principle risk.

This is a fairly unlikely outcome, but since they were issued with almost no risk premium to treasuries, I can understand why no one wants to own them.

Except that the fixed rate at which they would have done the deal in 2006 would be pretty juicy by today's standarrds.

And, yes, a bad RE crash would hurt some of the loans, but the pain would not hit the AAA tranche of the deal. It would nail the subordinated tranches, while the AAA tranche got paid out faster.

 

[pedorrero]

"Yet another example of the Fed (which is a privately owned corporation, not a government institution, yet controls the national monetary system) bailing out the predictable consequences of idiotic decisions made by politically well-connected cronies (generally, the big banks and investment industry)." would pretty well sum things up, I would say.

 

[RockOn]

I think what is missing is (the way I understand it) the Fed will only hold the mortgage paper for 28 days, then the banks will have to take it back. Am I correct?
If so, this it is hard to believe this is going to do much, except stop a very short term liquidity problem at a few banks, brokerages and S&L's. We'll see if they even show up to take the $200B on the 27th.

P.S. Looking at the ABX, it doesn't look too excited about this.
Historical ABX Graphs
The Junk spread liked it a little.
CDX Index History

One more thing, is this some more financial engineering to trick the public? haven't we had enough of that? the monetary base is not going up, i.e. no real help.

 

[frayne]

Another one of Bailout Ben's Boneheaded Blunders ?

 

[ziggy29]

I think what is missing is (the way I understand it) the Fed will only hold the mortgage paper for 28 days, then the banks will have to take it back. Am I correct?
If so, this it is hard to believe this is going to do much, except stop a very short term liquidity problem at a few banks, brokerages and S&L's. We'll see if they even show up to take the $200B on the 27th.

It remains to be seen. What the Fed is apparently hoping is that the market needs some time to settle down, re-evaluate things and realize that they're throwing out the baby with the bathwater. The Fed is only swapping Treasuries for the baby, not the bathwater. If the next 28 days can calm the secondary credit markets to the point where they realize they overreacted in fear about the cream of the crop in terms of mortgage securities, then the mission will have been accomplished.

Let's face it -- if the prime credit-seekers out there can't readily get a mortgage with 20% down, we're screwed and this Fed move is the least of our concerns.

 

[RockOn]

It remains to be seen. What the Fed is apparently hoping is that the market needs some time to settle down, re-evaluate things and realize that they're throwing out the baby with the bathwater. The Fed is only swapping Treasuries for the baby, not the bathwater. If the next 28 days can calm the secondary credit markets to the point where they realize they overreacted in fear about the cream of the crop in terms of mortgage securities, then the mission will have been accomplished.

Let's face it -- if the prime credit-seekers out there can't readily get a mortgage with 20% down, we're screwed and this Fed move is the least of our concerns.

Could it be that the issue is not that it's just a liquidity problem? "It's throwing out the baby with the bathwater" is not really the problem. Possibly what is happening is that nobody wants mortgage paper because they are afraid, even with 20% down, the prices might drop more than that and then even the AAA's will be upside down? That would make it a solvency problem, i.e., the new plan will not work.

 

[Hamlet]

I think its pretty unlikely that fixed rate prime mortgages with 20% down are ever going to present a solvency issue, even if the real estate market goes down enough to make people upside down in them.

People with good credit who put 20% down are very unlikely to be willing to walk away from a house, even if they know it is worth less than that currently. I think that as long as they don't lose the ability to pay, most people in that situation will keep making their payments. They will hope for a recovery, and eventually they will get one.

Even if the market value of my house went down 50% and I was underwater, I'm not wrecking my credit to walk away.

The people walking away now are mostly people who didn't have much money in the house anyway.

In order for those loans to go bad in large numbers, I think it will take a 70s style nightmare recession. A massive extended spike in unemployment is the only fear for these mortgages.

Could it be that the issue is not that it's just a liquidity problem? "It's throwing out the baby with the bathwater" is not really the problem. Possibly what is happening is that nobody wants mortgage paper because they are afraid, even with 20% down, the prices might drop more than that and then even the AAA's will be upside down? That would make it a solvency problem, i.e., the new plan will not work.

 

[RockOn]

Good points.

Let me go through an example of what a worse case could be. Say I have about 40% equity in my house, with an ARM that is fixed for 4 more years. It is just into the jumbo category. Let's say prices drop 31%. In four year when I want to refi, my equity is down to 9%. Not only will I have a hard time finding a refi, I now need PMI if I could. Let's also say inflation does get out of control and Libor is now 9%, my arm resets to 11.25%, my payments almost tripled. Rather than stay and make the huge payments, I might just write it off and walk. If I tried to sell it, most of the 9% would just go to the realtor. I could buy something with much cheaper payments, from someone else in trouble, with the higher interest being thrown off on my fixed income investments. I could use seller financing or pay cash. I'm retired and don't really care what my credit score is. I could also rent for much less, making my cash flow much easier to handle. (Cash flow could be the problem.)

So even in that case, starting with 40% equity, my loan might not be safe if the price drops 31%. (The price has likely fallen 10% already.)

Is that way too far out there in the range of possibilities?

 

[barbarus]

They are loaning treasury dealers treasuries and for collateral they are taking AAA mortgage backed bonds issued by Fannie, Freddie, Ginnie and private issuers (Wells Fargo, etc.). Effectively, they are loaning against the safest, cleanest mortgage bonds in existence, many of which already have an explicit or implicit guarantee from the federal government.

Why are the safest, cleanest federally-backed mortgage bonds in existence in trouble anyway? Such a financial instrument should rank just below treasuries in stability and safety.

 

[barbarus]

Some conjecture on triple A.

Bloomberg.com: Exclusive

 

[boont]

Inflation?

"Let's also say inflation does get out of control"

If inflation gets out of control then the house in question is most likely going to have increased in value. Which would negate some of the problem you suggest.

b.

 

[RockOn]

"Let's also say inflation does get out of control"

If inflation gets out of control then the house in question is most likely going to have increased in value. Which would negate some of the problem you suggest.

b.

Maybe, but right now prices are dropping like a rock and inflation is as high as it has been in a long time. After a bubble, I wouldn't bet on house prices rising with inflation. (If inflation goes up and rates are rising, house become less affordable, prices might drop instead of rise, look out your window, it's happening right now.)

 

[Hamlet]

Certainly that is a possibility. That scenario is why I'd almost always go with a fixed mortgage. With ARMs you are gambling that we don't get run-away interest rates. I don't know how they determine the AAA ratings, but I personally feel that there are very few groups of ARMs that should be AAA. I have know idea how my standards and the banks' match up.

It really boils down to how bad the economy gets. If inflation is out of control, but wages are rising with it, people will have added income to make the higher payments.

Your scenario is really 70s style stagflation. If that happens, we are going to have real pain, no doubt about it.

Good points.

Let me go through an example of what a worse case could be. Say I have about 40% equity in my house, with an ARM that is fixed for 4 more years. It is just into the jumbo category. Let's say prices drop 31%. In four year when I want to refi, my equity is down to 9%. Not only will I have a hard time finding a refi, I now need PMI if I could. Let's also say inflation does get out of control and Libor is now 9%, my arm resets to 11.25%, my payments almost tripled. Rather than stay and make the huge payments, I might just write it off and walk. If I tried to sell it, most of the 9% would just go to the realtor. I could buy something with much cheaper payments, from someone else in trouble, with the higher interest being thrown off on my fixed income investments. I could use seller financing or pay cash. I'm retired and don't really care what my credit score is. I could also rent for much less, making my cash flow much easier to handle. (Cash flow could be the problem.)

So even in that case, starting with 40% equity, my loan might not be safe if the price drops 31%. (The price has likely fallen 10% already.)

Is that way too far out there in the range of possibilities?

 

[Texas Proud]

Certainly that is a possibility. That scenario is why I'd almost always go with a fixed mortgage. With ARMs you are gambling that we don't get run-away interest rates. I don't know how they determine the AAA ratings, but I personally feel that there are very few groups of ARMs that should be AAA. I have know idea how my standards and the banks' match up.

I am not sure if you know about the CMOs.... but here is a bad attempt to show you can have AAA paper...

You are looking at the 'whole' loan... and saying how can it be AAA... well, look at the one loan... say it is $100,000...

Well, I buy the first $10,000 of that loan... I get my interest FIRST, and my principal FIRST...

Someone else buys the next, say, $80,000... and gets his interest second and principal second...

And then the bank or someone else owns the last $10,000.....

SO, if the person stops paying... then nobody is being paid... but, I own the first $10,000 in principal whenever it starts to pay again... SO, we repo the house, have costs etc... the price goes down 40%.... well, they still have $60,000 to pay to the holder....

I get my $10,000 PLUS any unpaid interest... I am whole... do you not think this is pretty much AAA kind of paper?

Now.. the guy in the middle got (let's say) $40,000... so he got hit for 50% of his money plus lost interest....

The last guy wrote off his investment a few quarters ago... never expecting to get anything from this loan....

 

[Razor]

After reading all of the above I am still confused.
Do you people think this was a good move by the FED or could it have some bad consequences. If it was a good move why didn't they do it before?

 

[brewer12345]

I think it was a necessary, good thing. I think t took them a bit because we are in uncharted waters here and they had to figure out what was needed, how to do it, and how much of it to do. The Fed has openly said they will work out the details with treasury dealers and may upsize the program, so clearly the how and how much are still in flux.

 

[al_bundy]

Absolutely correct -- and to add to this, this is important because many of the financials which were melting down were being killed by margin calls. The prices of even these extremely high-quality mortgage securities were falling out of a combination of fear and an excess number of sellers. That triggers margin calls, which forces more selling into a market with no buyers, and you started seeing very good paper getting killed out there. By letting these institutions borrow Treasuries (which aren't suffering the same fate in the market) in place of their currently struggling, less liquid securities, these institutions can stabilize their balance sheets and fend off the margin calls, *hopefully* long enough for these markets to regain some sanity so they can get their original paper back.

That's how I understand it, anyway. This is not a bailout, and especially NOT a bailout of subprime (which is not included in this scheme).

so when a lot of companies close out the 1Q in less than 28 days will they count the treasuries as assets on their balance sheet and magically remove the supposed AAA paper they can't sell? will that come off the balance sheet for reporting purposes and magically appear after 1Q earnings are set in stone?

 

[brewer12345]

Two observations:

1) this will almost certainly be recorded as a borrowing on balance sheets.
2) it will only affect the 20 primary treasury dealers, as they are the only ones eligible to directly participate.

 

[al_bundy]

what i meant is will this somehow wash away the mortgages on the balance sheets

say BSC has $20 billion of these and the current market value is $5 billion. they give these to the Fed this week and get $20 billion of T-Bills. come end of march when they close the books on 1Q, do they still count these mortgages as being on their books? or are they washed away only to reappear for 2Q?