A Step In The Right Direction

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Today the Fed announced two initiatives designed to hasten our emergence from the financial crisis (http://www.federalreserve.gov/newsevents/press/monetary/20081125a.htm and http://www.federalreserve.gov/newsevents/press/monetary/20081125b.htm.)

In the Fed’s own words:

“…the Term Asset-Backed Securities Loan Facility (TALF), (is) a facility that will help market participants meet the credit needs of households and small businesses by supporting the issuance of asset-backed securities (ABS) collateralized by student loans, auto loans, credit card loans, and loans guaranteed by the Small Business Administration (SBA).

“Under the TALF, the Federal Reserve Bank of New York (FRBNY) will lend up to $200 billion on a non-recourse basis to holders of certain AAA-rated ABS backed by newly and recently originated consumer and small business loans. The FRBNY will lend an amount equal to the market value of the ABS less a haircut and will be secured at all times by the ABS. The U.S. Treasury Department--under the Troubled Assets Relief Program (TARP) of the Emergency Economic Stabilization Act of 2008--will provide $20 billion of credit protection to the FRBNY in connection with the TALF….”

“New issuance of ABS declined precipitously in September and came to a halt in October. At the same time, interest rate spreads on AAA-rated tranches of ABS soared to levels well outside the range of historical experience, reflecting unusually high risk premiums. The ABS markets historically have funded a substantial share of consumer credit and SBA-guaranteed small business loans. Continued disruption of these markets could significantly limit the availability of credit to households and small businesses and thereby contribute to further weakening of U.S. economic activity. The TALF is designed to increase credit availability and support economic activity by facilitating renewed issuance of consumer and small business ABS at more normal interest rate spreads.”

In addition:

“The Federal Reserve … will initiate a program to purchase the direct obligations of housing-related government-sponsored enterprises (GSEs)--Fannie Mae, Freddie Mac, and the Federal Home Loan Banks--and mortgage-backed securities (MBS) backed by Fannie Mae, Freddie Mac, and Ginnie Mae. Spreads of rates on GSE debt and on GSE-guaranteed mortgages have widened appreciably of late. This action is being taken to reduce the cost and increase the availability of credit for the purchase of houses, which in turn should support housing markets and foster improved conditions in financial markets more generally…..”

The Fed, with the Treasury’s assistance, wants to boost household purchases of durable goods (by freeing consumer credit) and new homes (by freeing mortgage borrowing). These measures should help.

But note the dire conditions in the asset-backed and mortgage-backed securities markets as revealed by the following excerpts from the Fed’s press release:

“New issuance of ABS declined precipitously in September and came to a halt in October. At the same time, interest rate spreads on AAA-rated tranches of ABS soared to levels well outside the range of historical experience, reflecting unusually high risk premiums. ……….Spreads of rates on GSE debt and on GSE-guaranteed mortgages have widened appreciably of late.“

Will the Fed’s actions be sufficient? To what extent are households reducing their purchases of durable goods and homes because they can’t obtain credit and to what extent are households reducing their purchases because they want to protect their balance sheets? And what role does the ongoing collapse of home prices contribute to the crisis and households’ desire to protect their balance sheets?

Perhaps a general moratorium on home foreclosures and massive assistance to indebted homeowners, by attacking the root cause of the crisis (collapsing home values), is the requisite first step that must be taken before other measures can become fully effective.

© 2008 Michael B. Lehmann