Tuesday, March 20, 2007

The Fed Prop and Other Dangling Mortgage Shoes

There's just no doubt that the cash spigot is wide open not only at the Federal Reserve by way of its so called "window" at the New York Fed Bank, but also at the U.S. Treasury. The figures for Monday alone show that a 1-day $10.5 bln repurchase (repo) agreement was conducted at the NY Fed and another $5-1/2 BILLION was injected from the U.S. Treasury through a transaction known as a Term Investment Option, or TIO. That's $20-BILLION in a day. This is temporary cold, hard cash that can go directly to money desks on Wall Street to influence the markets, or it can even be loaned out by the broker dealers which count among their ranks the biggest names in banking. Thanks to the marvel of fractional reserve banking billions in short term loans can still add massive amounts of money to the economy even if the original 1 day to two week loan is paid back as promised.

Yes, the Fed policy markers are going to fool everyone on Wednesday by saying their standing pat on interest rates, or that rates must remain steady because inflation is a danger. Behind the scenes with competition from the Treasury to dole out cash, the Fed continues to pump the system with liquidity and Fed 101 says flooding the economy with money is akin to loosening credit!

Why do this? One reason is that the mortgage mess is far from over. Everyone calls it subprime, subprime, subprime, but the fire is spreading to different types of loans which are not necessarily relegated to dungeon level credit scores. Here's a note I received from a hedge fund manager earlier in the day:

  • "Just FYI, i am sure the market as discounted part of this already... Next month, 3 year ARM holders will understand why that was a bad decision. There are 2 waves of ARM mortgage rate increases coming. The first wave will occur in April on 3 year ARMs. This is hard to believe, but if interest rates remain the same in the next few weeks, then these ARM mortgage holders will see a 100% increase in their interest rate. If they were to refinance today, they would see a 60% increase in their rate. The second wave of increases will begin this Summer on the 5 year ARMs, and will continue to run for the next few years unless homeowners refinance. The best hope these people have now, is for us to have a large enough slowdown in the economy that would cause Bernanke to lower interest rates.
    While some market analyst were only worrying about defaults coming from sub-prime loans, they forgot to look at the mortgage defaults that will occur because of the 3 and 5 year ARMs. What this means is that we are likely to see these problems filter down to the banking industry, and that would put pressure on the market. Analyst are telling us that these problems are not affecting the banks. The reality is, that these problems take time to filter down to banking financials. Over the next few months, you will hear how banks will have to increase their default reserves, and how it will begin to affect their profits."

That email gives a sense of better perspective as to why there's such great urgency on the part of the entities run by Treasury Secretary Paulson and Fed-Head Bernanke to flood the markets with liquidity: The first wave of subprime implosions which have featured the demise of 41 subprime lenders according to Aaron Krowne's count thus far is only the beginning. There's a long way to go before the contagion reaches the top of the food chain and it would seem our monetary authorities are trying to protect or insulate our economy and markets from the next round of mortgage shocks.

I wish I knew what was really on the minds of Helicopter Ben Bernanke and Agent Paulson, at least with respect to the economy, because when Bernanke says the economy is on a path of moderate growth, or Paulson says subprime is contained I just don't believe them given what their organizations have been up to.

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