riskier borrowers, low quality collateral concentrated on real estate, questionable appraisals for market prices and "low, low rates". Is the Fed turning itself into a sub-prime lender? If I were a bank examiner, I would want to have a quiet word with Mr. Chairman about his lending practices
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WEDNESDAY, MARCH 19, 2008
The Fed As Bank
The Federal Reserve may be a central bank with special rights and
obligations, but in the end it, too, is a bank and has to be very
careful who it lends to and what kind of collateral it accepts in
exchange.
From a bank analyst perspective, during the last few months the Fed
has become increasingly more lax in its lending practices. It is
financing highly leveraged investment banks and brokers and accepting
a wide range of illiquid securities as collateral, particularly MBSs.
Let's look at the Fed's consolidated balance sheet (click to enlarge):
As of March 12, 2008 the Fed had almost $900 billion in assets, of
which $700 billion were in Treasury bills and notes and the rest in an
assortment of repos, the TAF facility, etc. The most recently
announced programs like the TSLF ($200 billion), the open-ended
discount window facility for investment banks/brokers and the $30
billion loan to Morgan (i.e. Bear's toxic assets) are not shown yet.
When those hit the books in the next few weeks, the asset mix will
change drastically. The Treasury holdings will go down and be replaced
by an assortment of GSE and private label securities. The Fed's risk
exposure will jump higher, and significantly so.
Like any other bank, the Fed does not have an unlimited amount of
money to lend - all it has is about $700 billion in Treasurys that it
can exchange for other, less marketable securities (and it has already
announced programs for a big part of that). In contrast, US home
mortgages alone amount to $10.5 trillion; if things keep unraveling,
the Fed's balance sheet will prove very small for the role it has now
chosen for itself.
As for the liability side, the Fed has issued about $800 billion of
its own Federal Reserve Notes, i.e. dollars. Our currency is thus
increasingly going to be backed by lower quality, riskier assets that
no one else wishes to buy or lend against, instead of Treasurys. In
effect, Mr. Bernanke is betting the farm on a quick real estate/
mortgage turnaround and a very shallow recession. Worse still, instead
of charging a higher interest rate for the loans made against the
riskier collateral, the Fed keeps cutting rates.
And just how sound is Mr. Bernanke's "bet the farm" wager on a quick
turnaround of the US real estate market? Judging from the following
chart, not very sound at all. Unlike previous real estate boom cycles
that lasted 2 to 4 years and peaked at 700-800.000 new homes sold per
year, the one now busting lasted 13 years and peaked in 2005 at
1.300.000 units. There has been a lot of housing demand satisfied for
many years to come and the downturn will not likely end soon.
Without Greenspan's negative real interest rates after 2000, the cycle
would have probably turned down (red line), avoiding the bubble of
2002-06. Based on this hypothesis, there have been almost 3 million
"extra" homes sold (black line minus red line), creating a fundamental
housing demand deficit that won't go away even if credit becomes cheap
again.
Let's summarize: riskier borrowers, low quality collateral
concentrated on real estate, questionable appraisals for market prices
and "low, low rates". Is the Fed turning itself into a sub-prime
lender? If I were a bank examiner, I would want to have a quiet word
with Mr. Chairman about his lending practices.
And if I were a shareholder or creditor of the Federal Reserve Bank
(remember what its liabilities are), I would be worried. As, indeed,
so many already are - they are those who are exchanging their dollars
for other currencies and commodities.