Tuesday, November 25, 2008

The Fed May Be On The Verge of Buying Subprime Loans

It has been my contention since my March blog that the subprime crisis would eventually lead to the government buying subprime loans. I likened it to an icebreaker. Frozen subprime assets clogged banks', insurance companies', and other financial institutions' balance sheets and, thus, blocked the free flow of capital and normal economic activity. That is the reason that I was at first optimistic when the TARP plan was announced to do just as I had hoped. My optimism was dimmed when the TARP plan was altered in such a way that the purchase of the frozen assets was set aside in favor of direct government investment into the major banks. I was certainly not against the infusion of government capital into the banks, there will have to be more of that, but in my judgement, the frozen assets won't just thaw on their own. They must be broken up by the government. Today's announcement that the Fed will buy up to $600 billion in Fannie Mae and Freddie Mac notes and mortgage backed securities (MBS) is a giant step in the right direction and should push mortgage rates lower and benefit housing. It does not assure that subprime assets will be bought because the details of the plan have not yet been made public. But here is my thinking, today the Fed also announced that they were buying up to $200 billion in "AAA" rated asset backed securities backed by auto loans, education loans, credit cards, and SBA loans. The Fed's announcement regarding the purchase of mortgage backed securities made no mention of the ratings of the mortgages to be bought. I have a gut feeling that they plan to purchase mortgage backed securities with ratings lower than AAA. If they do that, they will begin the unfreezing process. The reason that I think the Fed will begin to buy loans with lower ratings is because there is a reasonably efficient market for AAA rated MBSs. It is the lower rated MBSs that are frozen. I'm hoping the lack of a rating announcement today means that the Fed is beginning the process of breaking loose the MBSs that include subprime collateral. If it does, it should significantly improve the housing market by freeing up billions of dollars that can be loaned to willing and qualified buyers of homes.