Two Big Speeches

Yesterday, President Obama laid out his housing plan in more detail and Fed Chairman Bernanke gave a speech and answered questions at a Press Club luncheon. Both speeches were significant.

First; Housing. I read through the factsheet on the Treasuries website as well and I think the plan has promise. From what I can tell there are two prongs. The government will use Fannie Mae and Freddie Mac (which they already control through conservatorship) to allow a wave of refinancing into lower monthly payments. They will get rid of the provision that these agencies can only guarantee a mortgage with at least 20% equity. Scrapping that provision will allow the agencies to refinance an estimated 4-5 million mortgages that were ineligible given the decline in home prices. This should prevent some homes from being foreclosed on, and it is likely to reduce monthly mortgage payments by a couple hundred dollars in many cases. Notably, speculators (who don't live in the home) and jumbo loans (referred to as "millionaire loans" in the Treasury factsheet) will not be eligible.

The second prong is a partnership with the banking industry to modify mortgage terms before a borrower goes into default. The government will lay-out a standardized set of criteria that banks must use if they want to participate in the TARP program. It sounded to me like this was really targeted at the subprime mortgage market since those loans were largely originated away from Fannie and Freddie, but it has the potential to impact the Alt-A mortgage market as well. This prong is estimated to impact another 3-4 million mortgages. You can read the specifics on the Treasuries website, but in summary the government will share the cost of lowering the interest rate on loans to bring them down to 31% of gross income. http://www.treas.gov/news/index2.html

Key point: We are all focused on whether this can stabilize housing prices, but I think the benefit to consumers' monthly cash flow is equally significant here. My rule of thumb is that a 1% reduction in the mortgage rate will reduce the monthly payment by 11%. The government is effectively lowering America's aggregate mortgage payment every month by allowing Fannie and Freddie to refinance loans they normally wouldn't and strong-arming the banking industry to do the same. The government will inject an additional $200 billion into preferred stock at the agencies to help absorb the potential losses and allow them to increase the size of their respective portfolios by another $50 billion, to $900 billion each.

Bernanke also spoke yesterday and addressed the issues of credit risk on the Fed's balance sheet and the question of whether the increase in the monetary base will necessarily lead to future inflation. I thought these comments were very timely and I was surprised the market didn't react more favorably.

As a quick background, the Federal Reserve has more than doubled the size of it's balance sheet to over $2 trillion dollars in the last year by adding a wide variety of new lending programs and asset guarantees. Bernanke pointed out that in addition to holding more collateral than they lend, they also have recourse to the institutions that borrow. So if the borrower can't repay the loan, the Fed has collateral and will have a claim against the institution as well if the collateral is not enough to cover the loan. The dollar swaps they have engaged in are with other central banks and here again, they received an equivalent amount of foreign currency at the time of the swap, so these are not uncollaterallized. Bernanke allowed that the transactions with AIG and Bear Stearns are riskier but they only represent 5% of the Fed's balance sheet and they felt the cost of allowing failures would have been higher.

The concern has been that the collateral the Fed accepts is much lower quality that they would normally have accepted. This is true of course and was deliberate as an attempt to help banks get short-term funding in a broken credit market. Bernanke's point is that if collectively we can save the banking sector, then the Fed will eventually be repaid even if the collateral has dropped in value because the claim. At the end of the day, if you think disaster and collapse are coming, then Bernanke's comments do not ease your concerns.

On the money supply: I know this is a topic of concern because I have heard the question come up many times over the last six months. Investors seem to understand that the Fed needs to increase the monetary base right now to offset the decline in leverage across the financial system, but will they be able to reduce it when the time comes or are we locked into a future of high inflation?

Bernanke had a few interesting things to say. The vast majority of Fed lending has a short maturity, so once the credit markets normalize they can simply let the loans run-off. He also said, and I thought this was especially helpful, that the terms of the loans are specifically written to be attractive now in a time of crisis, but unattractive in a normal credit environment. Or put another way, once things normalize, the banks themselves will not want to roll the loans because they will be able to get funding from the credit market at more favorable terms. And finally, he pointed out that several of the programs were instituted under 13(3) which requires that conditions in financial markets are "unusual and exigent". By law, these programs will have to be fazed out when the financial markets are functioning normally. I realize that these terms are subjective, but the point is that some of these programs are designed to be temporary and Congress could force them to be discontinued at some point.

For anyone wanting a great synopsis of what the Fed is doing, I highly recommend that you read the transcript to Bernanke's speech. http://www.federalreserve.gov/newsevents/speech/bernanke20090218a.htm

One other great reminder from Bernanke's speech. The press has been fixated on whether the banks have been lending more or less since they received capital infusions, but Bernanke pointed out that the real reduction in lending has happened as a result of the securitization markets shutting down. The banks are effectively treading water trying to stay alive, but the securitization market has virtually dried up and it was a very large source of consumer lending. So while the press has distracted most of us (myself included), the Fed has been working hard on the TALF program to stimulate renewed securitization of consumer loans.

To beat a dead horse, make sure you think about all of this together: the Fed's aggressive actions to keep the system functioning, the Treasury recapitalizing the banking system and trying to remove the overhang of bad assets, and the Congress trying to stimulate the economy with tax breaks and job creation.