Sunday, September 7, 2008


Over the past few weeks there has been much criticism over the potential (now actual) Government Sponsored Agency “GSE” bailout due to the potential cost to taxpayers, the moral hazard it would encourage, etc... I do not disagree with most of these criticisms, but the cost of NOT doing anything would be much greater. To show the potential benefits of the bailout on both housing and credit markets, which in turn will benefit the economy, below is how the bailout will unfold in a “best case” scenario. While I do not believe it will solve all of the problems detailed below (or even a fraction of them) in this manner, I do believe it is important to look at the bail-out in terms of a "glass half full" and how it can help alleviate the liquidity problems associated with today’s credit markets.

Specific features of the bailout that impact the outcome to the credit market include the Feds new liquidity facility, the goal to increase Fannie and Freddie's mortgage-backed security portfolios through the end of 2009, the right for the Treasury to actively purchase MBS in the open market to reduce spread (and cost to future homeowners), and the future goal to reduce the GSE balance sheet by 10% annually starting in 2010. In the first part of my "perfect world" analysis, I predict that these features (and others – go here for 10 key features) will help put a floor on housing prices.

Homeowners that already qualify for high quality prime loans will not be as impacted directly by the new moves by the Fed. Why? Agency spreads are near historic wides, but absolute levels are already near historic lows.

HOWEVER, borrowers that do not currently qualify for these low rates should see their rates drop dramatically. Why is this important? If a homeowner that qualified for a 9.5% rate can access a 7% government “subsidized” loan, their buying power increases by almost 25% (all else equal).

These “subsidized” loans will prop up the housing market as the size of the payment made is what truly matters for a homeowner (specifically one that intends to live in that home for the foreseeable future). Importantly, these rates are not “teaser” rates that reset, but more manageable fixed rates for the life of the mortgage.

The goal is to entice the marginal buyer to come to the market / have “bad loans” refinance at more manageable rates. In the past 6-12 months potential homeowners have been sitting on the sideline as prices continue to make new lows (nobody wants to catch a falling knife). With the new “bailout” limited time horizon (increasing balance sheet through 2009), this SHOULD bring a sense of urgency for new homeowners (expect emphasis on the "limited time offer" aspect).

If these low rates do put a floor on home prices sooner than later, this should benefit the owners of subprime / Alt-A securities that have priced down as delinquencies have risen at historic levels. If the market bottoms and these owners are able to refinance at the new lower rates, get who gets off the hook? THE EXISTING MORTGAGE OWNERS who get paid back at PAR for all loans refinanced.

Banks own a lot of these mortgage securities that have priced down and in response, over the past 6-9 months banks have attempted to delever as their equity has been written down / capital has been so difficult to come by. This system wide delevering only caused these entities to be more levered. How is this possible?

Well, if one bank attempted to delever, they’d be successful. When every bank attempts to do so at the same time, it only makes the problem worse! Let’s take a look…

As these banks all sold off assets at the same time, these assets sold priced down in value as the entire market was selling into a distressed AND illiquid market. This in turn reduced the price of assets remaining at the banks. When that happened, they were forced to write down even more assets / equity, resulting in leverage HIGHER THAN WHEN THEY INITIALLY BEGAN.

If these assets snap back even partially in value, the reverse happens. In fact, I expect a portion (maybe a tiny portion) of the underlying mortgages in securities marked as low as 60 cents on the dollar to repay at PAR when homeowners sell to new owners at the “subsidized” rate or are able to refinance themselves. In addition, liquidity injected into the market through the Treasury’s outright purchase of mortgages should bump up the price. The result will be improved leverage ratios at banks, which will slow the asset selling process we've seen from banks. In fact, expect well funded banks to actively buy securities in the market in the coming weeks / months.

It's also important that the bailout makes banks much more attractive for outside investment (think Sovereign Wealth Funds). Once new capital is injected and their balance sheets are improved, new loans can be made. This should result in improved (lower) rates for non-government mortgages.

If this all works out as I detailed in the above best case scenario, a functioning credit market at no cost to taxpayers results. What likely will happen? After everything that has transpired over the past 12+ months, I have no idea though I do expect credit markets to more accurately reflect the actual economy and not the lack of liquidity in markets. The result of which might scare investors just the same...

1 comment:

  1. Jake - thanks very much for this. One of the few (almost only) balanced assessments running around. Lots of blogosphere comment about socialism and fascism and pretending we don't need a regulated market and haven't enjoyed the benefits.
    A quibble - potentially major. I think this makes the markets orderly and less prone to implosion but doesn't floor housing prices. That requires working thru the excess inventories which in turn requires various measures, e.g. Price:Rent, to come back to normality, or at least some semblance of rationality. You may also find this discussion of the wider implications and systemic risks interesting: