Saturday, October 17, 2009

See the attached graph. It shows the various assets currently held by our nation's Federal Reserve, compared month-to-month. The numbers are in billions, so there are approx. 2.1 trillion dollars in assets at this point. There are all sorts of things: treasury bills, ownership of troubled companies, assets bought from troubled companies that those companies could not sell to anyone else, along with other sundry things.

Notice how the total sum went from less than one trillion to over two trillion practically overnight when our ongoing depression started, and has hovered around that point since then. This means they had to come up with over a trillion dollars (either borrowed or created out of thin air) to buy those assets and augment their balance sheet.

Now notice the asset class "MBS". Know what that is? It stands for "mortgage backed securities". What happens is, a bank lends a homebuyer money to buy a home. This mortgage represents an asset - an expectation of future income for the bank as the buyer pays off the mortgage, balanced against the risk of the homeowner defaulting and not paying the mortgage back.

However, banks don't always intend to keep these mortgages. Instead, they bundle hundreds and thousands of these mortgages together into what we call MBS's, and sell them off. The buyer of these MBS's then get the revenue from the homeowners paying off their mortgages. If everyone pays off their mortgage, then the MBS is a profitable asset. If enough people default, it is not, and the buyer doesn't get back what they paid for the asset.

Notice that the Federal Reserve owned zero $ in MBS's as of February of this year. This is because it really isn't the Fed's business to invest in the real estate market (or any other non-government market, for that matter). However, starting in March they have started buying them at a consistent pace of $100 billion every month. Since the total asset level has remained relatively flat, they have sold other assets to buy these MBS's.

While I don't have an exact figure on mortgages originated every month, this $100 billion per month represents a substantial percentage of all new/refi mortgages that month. It could be 50% or more. Basically, they are buying half or more of all the mortgages formed every month. Thus the Federal Reserve "owns" millions of houses, and also owns the risk associated with all those homeowners being able to pay off our mortgages.

This is not the only way our government is meddling in the real estate market, but it is one of the largest and most significant, even though most of my readers probably haven't heard about it. Combined with the efforts of other agencies like Fannie Mae and Freddie Mac, along with the FHA mortgage relief, free $8,000 tax credit for first-time buyers, et cetera, our government is influencing the real estate market, property values, and mortgage rates, to an astonishing degree. And $100 billion a month in MBS's is an enormous amount of money - $1.2 trillion a year. That is almost the amount of the entire budget deficit our government will run this year.


1. Why would they do this?

Answer: Keeping real estate prices artificially high is one of the major priorities of our government. Buying up all these mortgages helps accomplish this in two ways:

First, mortgage rates have to stay low - very low - unprecedentedly low. If rates go up, buyers have to spend more on interest, meaning they have less money for the house itself. They'll also be less willing to buy in the first place. So prices go down. The government has tremendous power to influence the interest rates that everyone has to pay to borrow, and they've used all that power to get mortgage rates down below 5%.

The problem is, a 4.85% rate isn't very lucrative for a mortgage company, particulary in the very scary economy we've got right now. People are being laid off in droves, and mortgage defaults are a mounting tsunami. They'd rather charge way way more for a mortgage, even to a "safe" borrower. Since they can't, in many cases they'd rather just sit on the money than take on the risk of a new mortgage. So even though rates are enticingly low, lenders aren't willing to lend the money. This is one of the reasons it's been hard to get a mortgage for the past year. With fewer mortgages granted, sellers have a hard time finding buyers and prices go down.

By buying up so many MBS's, however, the Federal Reserve takes that risk right out of the lender's hands! So what if the borrower loses their job? - that's the government's problem. So what if the rate is a rinky-dink 4.7%? It doesn't affect the bank! The lenders and mortgage companies are motivated to go ahead and write whatever mortgages they want, because ultimately the risk for many of them is taken off their hands by our government.

Thus sales are up, rates are down, and real estate prices stay much higher than they would without trillions of dollars of our tax money propping the whole market up.

2. How much longer can they do it?

Answer: Take a look at the graph. Even while buying $100 billion of MBS's a month, the Federal Reserve has not increased the overall value of its portfolio. They have sold off or retired other assets, and rather than using the money to pay off debt or return it to taxpayers, they are using it to buy mortgages. The problem is, they can't do this forever because they will eventually run out of other assets to sell off. Right now MBS's constitute about 1/3 of the Fed's portfolio. Let's assume they can't sell off the US Treasury notes they continue to accumulate, so that's $700 billion they can't touch (the subject of another essay - they really can't sell those right now without some very frightening consequences). That leaves about $700 billion in other assets - seven months max, assuming they can sell EVERYTHING (which they can't). So sometime in the next six months, they will no longer be able to keep buying up MBS's the way they want to. Next year they'll have to choose one of the following:

a. borrow more - basically double the government's deficit for the year
b. create a trillion dollars out of thin air - that will dilute the value of every dollar, sabotage our savings, and make it harder for our government to borrow money
c. stop buying the MBS's

3. How much risk does this represent?

A lot. The government is stockpiling enormous risk in these mortgages. If unemployment increases unabated and mortgage defaults continue to pile up, these MBS's will have billions and billions in losses that taxpayers will have to cover. Additionally, if the market changes and real estate values go down like they really should, more and more people will be underwater on their houses, and be motivated to walk away, increasing MBS losses even more. Finally, in such a scenario the Federal Reserve will have a very rough time selling these risky assets to anyone else. "We" will be stuck with them.

4. What might happen when they stop buying $100 billion every month?

Mostly the bad things I described in #3 will happen. At this point they cannot stop buying these things without a whole host of Really Bad Things. They are going along with it, hoping that the economy will heal before they run out of money. If it doesn't (which, with 10% unemployment and enormous private debt, it won't), they will probably feel forced to borrow more or turn on the printing press to keep buying MBS's, taking on more and more risk as they try to avoid the unavoidable.

5. What should they have done instead?

Good question, and one I'm not qualified to answer. But my opinion is that the problems they are trying to avoid are unavoidable, and that their efforts are essentially in vain. So they really could have done NOTHING and, I think, been better off. The way to recover from a bubble is to let the bubble pop. Unfortunately, even now our government is enthusiastically pumping air into the real estate bubble, and it's costing a lot of money to do so.

6. What should we do?

Food storage. Stay out of debt. Don't fall in love with the things of the world - reserve your love for your families, friends, and God. The prophets were really, really right about that stuff. All our idols might crumble before our eyes, but our future is bright if we remember what really matters.