The Fed said it would lend Wall Street as much as $200 billion from the central bank's own trove of sought-after Treasury bonds and bills for 28 days in exchange for a roughly equivalent amount of mortgage-backed securities, including some that can't ordinarily be used in transactions with the Fed. Uncertainties about the value of the underlying mortgages, plus forced selling by some investors to repay broker loans, have led many investors to spurn these securities, making them especially difficult to trade.
By taking some of these securities on its own books, the Fed is seeking to make its primary dealers -- the network of 20 Wall Street firms with which it typically does securities business -- more comfortable buying them from their own clients. It hopes this could lead to higher prices and thus lower yields on the mortgage-linked debt. A decline in those yields could help banks offer lower interest rates to prospective homebuyers.
The Fed is engaging in a massive repurchase agreement program:
An agreement with a commitment by the seller (dealer) to buy a security back from the purchaser (customer) at a specified price at a designated future date. Also called a repo, it represents a collateralized short-term loan for which, where the collateral may be a Treasury security, money market instrument, federal agency security, or mortgage-backed security. From the purchaser's (customer's) perspective, the deal is reported as a reverse repo.
There is one central problem with the Fed's plan. In 28 days, all of the questionable securities go back on the books of the borrowers. The central problem right now isn't the cost of money -- interest rates are still incredibly low by historical standards. The problem is counter party risk, also known as default risk:
The risk that companies or individuals will be unable to pay the contractual interest or principal on their debt obligations.
Notes:
In other words, this is the risk that you will not get paid.
Consider the following facts:
236 mortgage lenders have "imploded".
32 hedge funds have imploded
The latest FDIC Quarterly Banking Profile shows deteriorating credit conditions.
Banks have written down between $150 billion and $200 billion (the numbers differ depending on the news source).
UBS recently estimated that total losses from this mess would be $600 billion. Until that estimate was released, the total was estimated to between $300 - $500 billion. Assuming any of these estimates are correct that means we have at minimum at least abother $100 - $150 billion in writedowns to go.
Simply put, lenders are scared the borrower is going to default on a loan -- even a short-term loan. That means banks are making fewer and fewer loans. Given the facts, this caution about lending is entirely warranted.
The problems with the Fed's plan aren't the Fed's fault -- they are trying to do what they can to stimulate the financial sector. But nothing that they can do will rid the market of the central problem -- deteriorating balance sheets.
