Wednesday, March 12, 2008

Exchanging Bad Debt For Bad Debt

Well, one can accuse the Fed of many things, but not for being inactive. Not only have they reduced interest rates dramatically but they have come up with one scheme after another to reduce the increased risk aversion in some selected credit markets. The latest, as most of you have presumably already heard of, is called Term Securities Lending Facility, in which the Fed will essentially exchange Treasury (government) securities in exchange for mortgage backed securities. The purpose of this seems to be to reduce the yield spread between these two types of securities, which it probably will achieve although only to a limited extent. However, it will certainly not solve the underlying problems of the U.S. housing market and economy with too high levels of housing inventories and mortgage debt and too low savings rate.

In short, it won't have anything near the dramatic effects that Wall Street imagined based on yesterday's massive stock rally (arguably though, that rally may to a large extent simply have been based on the perception that the market was tecnhically oversold and this news was thus simply a false excuse for a rally). Nor is it really likely to have much of the negative effects that some argue. While certainly the mortgage backed securities could be characterised as bad debt, so can the Treasury securities with their pathetic yields, which are negative in real terms. The losses for the Fed from defaults on these securities could thus largely be compensated by the much higher yield on those that don't default. Both mortgage backed securities and Treasury securities should be considered bad debt, as both is likely to inflict losses on anyone who invests in them. In the case of Treasuries in the form of a negative real yield, in the case of mortgage backed securities in the form of defaults on some of them.

And if (big if here) the Fed views this as a substitute for continued dramatic reductions of the Fed funds rate, then this is in fact good, as in being a lesser evil. However, if the Fed views it as a complement rather than substitute, then that will not hold.


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