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333 comments on DrumBeat: August 9, 2007

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NC on August 9, 2007 - 1:12pm Permalink | Subthread | Parent | Comments top

I have a very naive question about money, especially the electronic kind.

So we have a number of mortgages that were set up based on inflated house prices that have rates too high for the borrower. These loans are not being paid back causing a liquidity crunch to the institutions that created the money for the loan.

So in my simple mind, as these properties go into default and devalue, some of the money just evaporated. This is just the reverse of how the money was created in the first place, it was blinked into existence via the mortgage loan process.

The fall out of this is that the currency that was created on paper is not being paid back in reality, or at least not enough of it is getting back to the bank to maintain a positive cash flow. Ultimately this means the properties will lose value and not all of the money created will get back to the lender.

My question is this. Why can't the Fed and other central banks bail this out by giving enough cash directly to the lenders to cover their shortfalls of defaulting payments and allow them to rework their long term income stream back to a positive cash flow?

Some percentage of that mortgage created money is gone for good but the Fed can just create some new money to take its place that can be used for something other than originating mortgages.

I don't see it as a requirement that the Fed has to cover the entire defaulted value in 2007 (many of the loans must be 15 years or longer with interest accruing all the time), just keep the cash flow close to what was planned. Over time the housing stock will be revalued (but still retain value above $0) and allow everyone involved to cope with much lower profits than expected. My thinking is that all the new houses built did add assets to the economy just not nearly as much as the loan valuations projected.

I would think the goal of the Fed and Central banks is to get cash into the hands of these big originators but prevent them from using it to originate new risky loans going forward. This keeps the money circulating but gradually shrinks the risky debt back to a manageable small percentage. What's missing in my assessment of why this won't work?

Hopefully there are competing posts addressing this so I get a better scope of how the money supply works.

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wstephens on August 9, 2007 - 10:15pm Permalink | Subthread | Parent | Comments top

NC,

The Federal Reserve is restricted and cannot buy private securities (mortgage debt). This is the job of Fannie Mae and Freddie Mac -- gov't "sponsored" enterprises (originally) to help finance mortgages and promote homeownership which the government wanted to promote. Later they were "privatized" into companies.

There was a "rumor" printed in the Financial Times recently that Fannie and Freddie are going to be authorized to buy sub-prime (which they currently don't). Offically, I think, Fannie and Freddie are "private", but hardly anyone in finance thinks that they would remain strictly "private" in a mortgage debacle. I think they have their own regulator (OFHEO is it?).

Anyhow, the government/politicians will step in once people are shown on TV getting booted out of homes, re-federalize Fannie and Freddie (turn them back into "Federal National Mortgage and Federal Home Loan or whatever they were called"), and buy sub-prime mortgages, and eat the losses -- that's what the government is for! -- the ultimate bag holder! (note to libertarians: this is where libertarian policies go astray).

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NC on August 9, 2007 - 11:21pm Permalink | Subthread | Parent | Comments top

Thanks for the reply.

So I take it the closer the entity is to owning mortgages (as opposed to originally providing funds to those entities) the more the Feds hands are tied. I can see that the liquidity crunch will "appear" at the level of mortgage holders and can spread in both directions - down to people owning houses and up to investers - faster than the Fed can intervene.

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wstephens on August 10, 2007 - 7:32am Permalink | Subthread | Parent | Comments top

"faster than the Fed can intervene"

...and faster than the politicians even.

Interestingly, as I've posted elsewhere, it appears that sub-prime CDO investments were sold primarily to European and Asian investors -- so that may be why more investment blow-ups are happening overseas (while only the creators / facilitators are having problems here in the US). The ECB is doing much more "stabilizing" right now than the Fed.

A funny anecdote recently is that a US hedge fund was suing a mortgage servicing bank for re-structuring delinquent loans in a portfolio of sub-primes (which is the bank's fiduciary responsibility) because the hedge fund was "short" the mortgages -- what this means is that the hedge fund, which already had a 90% profit on the short position, wanted the banks to default the loans so the hedgies could make more money. Can you image the trial? -- "We've made 90%, and the bank is preventing us from making more! Kick those squatters out!". Good luck with a jury on that one.

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souperman2 on August 10, 2007 - 10:22am Permalink | Subthread | Parent | Comments top

Well they just did;

Fed Adds $19 Billion in Funds by Buying Mortgage Debt (Update3)

http://www.bloomberg.com/apps/news?pid=20601087&sid=aZ.cxsJa71xg&refer=home

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Substrate on August 10, 2007 - 1:44pm Permalink | Subthread | Parent | Comments top

So the federal government, which is running a deficit (aka debt) is using debt money to buy debt money which was probably chasing after debt money to begin with. And this is supposed to make people feel better? Right.

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333 comments on DrumBeat: August 9, 2007

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