Fed Trying To Buy Time, Say Economists

Source : The Business Times, March 13, 2008

Debenture spreads narrow in positive market response

(NEW YORK) A central bank plan to infuse the financial system with new cash is a temporary fix for the debilitated US mortgage bond and housing markets, but not a cure.

The programme announced by the Federal Reserve on Tuesday frees up money for mortgage loans and dealer bond buying in the two markets paralysed by limited funding and fears of bank failures, economists and analysts say.

'This is a tourniquet, it will staunch the bleeding, but it may not turn us around and bring the patient to health,' said Susan Wachter, real estate and finance professor at The Wharton School, University of Pennsylvania.

'This is designed to stop in its tracks what might otherwise be an old fashioned credit crunch where the banks simply themselves seize up,' Ms Wachter said. 'It's not a sure fire end of the crisis by any means.'

The Fed will let dealers use US agency debentures and agency mortgage bonds, as well as top-rated private label mortgage securities as collateral in the new lending facility.

This will be the first time the Fed takes non-agency residential mortgage bonds as auction collateral in its latest effort to add market liquidity. It already accepts this kind of paper as collateral from banks that borrow directly from the US central bank at the discount window.

The initial US$200 billion funding for the plan might be raised, according to the Fed. The size of the plan pales in comparison with the mortgage bond markets totalling more than US$7 trillion.

Historically high defaults and foreclosures froze mortgage lending to all but the highest quality borrowers, and closed many companies who relied on higher risk home loans. Trouble that shut down the sub-prime mortgage sector has now started cascading to higher quality loans, leading to a growing number of private and federal plans to restore order in the mortgage bond and housing markets.

The Fed said that the private-label MBS (mortgage backed securities) it would accept must be AAA-rated and could not be on watch-list for rating cuts. Possibly US$1 trillion of those securities were eligible, according to senior Fed staff members.

The market for private label bonds, or those backed by mortgages too large for Fannie Mae and Freddie Mac to buy, was stung too as lenders and investors grew more risk averse. A recent government plan to sharply, but temporarily, raise the size of loans those top two US home funding companies purchase should also provide short-term relief.

The Fed is 'buying time' by unfreezing markets for some highly illiquid assets, said Robert Eisenbeis, chief monetary economist at Cumberland Advisors and former Atlanta Fed executive vice-president. 'But liquifying those assets does not mean the funds will flow back into mortgage markets.'

There was an immediate and positive initial response in the MBS and agency debenture markets on Tuesday. Debenture spreads narrowed as much as 12 basis points versus Treasuries from some of the widest spreads in the decade-long history of Fannie Mae's benchmark and Freddie Mac's reference note programmes.

Agency mortgage bonds also outperformed Treasuries by a far margin after hitting the widest spreads in over 20 years before the Fed plan. Prices of 30-year bonds rose slightly while 10-year Treasury notes sank 1 1/4 point. An index of AAA-rate non-agency MBS that lost 43 per cent since September also gained slightly.

'Liquidity constrained financial institutions have been unable as well as unwilling to lend, so if you can free up that capability it's going to help,' said Margaret Kerins at RBS Greenwich Capital in Chicago. -- Reuters