Benanke and Co. are not addressing the core problem. The core problem is not the GSE qualifying mortgages which the Fed is buying in securities form (along with GSE debt). It is the so-called jumbo mortgages (original balances over $417,000) which are problems. Many of these mortgages are for homes purchased at the peak of the bubble. They cannot be refinanced via a Freddie, Fannie or Ginnie mortgage. Banks are very careful about to whom they lend above the GSE limits because it is very difficult to securitize these mortgages because, unlike GSE MBS in which the investors' principal is guaranteed by the GSEs, a so-called private label MBS is backed ONLY by the underlying mortgages. If they fail, you fail.
There is a populist movement which wants the banks to hold mortgages so that they will have "skin in the game" like in the old days. This sounds good on Main Street, but by going this route, even responsible borrowers would not be able to obtain mortgages. Even the largest banks would soon run out of lending capital. If bank used corporate bonds of covered bonds (corporates backed by a pool of mortgages), these bonds would be counted as debt on corporate balance sheets. To maintain acceptable Tier-I Capital ratios, banks would need billions of deposits or equity or preferred IPOs. Not going to happen except from the government (I.E. the TARP preferreds).
Even with the banks "leveraged gone wild" period considered, the damage to the economy need not have gotten this severe. If home prices were permitted to adjust (fall) to levels based on supply and demand early in 2008, we may have seen a recovery by now. What happened instead were several half measures to keep people in homes who could not afford to keep them and a push to refinance mortgages with balances higher than the homes true worth (as opposed to bubble value). These half measures kept home buyers out of the market as the waited for home prices to fall, believing (correctly) that the government would only make things worse.
The result has been a long slow bleed of home prices. This long slow bleed has eroded consumer confidence, reduced consumer spending and has caused the broader, even global, economy to sputter and stall (decoupling my butt). This has removed more potential home buyers from the market. The reduced demand from fewer potential home buyers promises to push home prices even lower. Now we are in a negative feedback loop. Home prices continue to fall, consumer confidence falls. layoffs mount and more home owners, even those who acted responsibly, fall behind on their mortgage payments as they lose their jobs.
Are home prices artificially low? Not according to the data. In many markets home prices are only approaching the pre-bubble levels of 2004 (Bloomberg News). This looks like a correction to me. However, Main Street and the politicians who pander to it believe that home prices should be immune from price cycles. Sorry folks, homes are commodities just like anything else. Their prices rise and fall for a number of reasons. Any attempts to interfere with market forces will be more harmful than helpful.
A few weeks back I discussed LIBOR-based floaters. Some concerns I had with the strategy of purchasing such preferreds was that their mechanics (how they trade and why) and where LIBOR was going and why were not understood. One of my concerns was that the TED spreads (spread between three-month LIBOR and the Three-month T-Bill will would narrow by the three-month LIBOR rate falling. This is what happened. As of Friday January 30th, three month LIBOR was down to 1.18% The TED spread, although still wider than normal (normal is 20 to 30 basis points). Current spread is about 95 basis points. With the Fed stating last week that it is going to keep the Fed Funds rate at or near zero for an extended period of time, I expect the TED spread to continue to narrow by three-month LIBOR rates falling. After all, one of the Fed's goals, as stated last year after Bear Stearns imploded, was to improve interbank lending.
Some investors may be saying: "So what, these preferreds have coupon floors." Although that is correct, the deeper LIBOR sinks, the more of an upward move in short-term is needed to get off of that floor. Also, in theory, the deeper LIBOR sinks and the further below the floor the raw coupon calculation gets, the cheaper these floaters should trade. Even if they don't sink much more, they sure as heck shouldn't rise in value (unless of course, investors who don't understand floaters come in and buy). I would wait a bit longer before jumping in to the floaters. LIBOR should fall a bit more.
One other aspect of these LIBOR based floaters of which investors should be aware. They are all preferred equity and rank below all debt and are equal to the government's TARP preferreds on the capital structure. Of course unlike publicly-traded preferred stocks, the government gave itself a cumulative feature.
Some investors question the advantages of moving only one step higher on the capital structure, from a traditional preferred to a trust preferred. In reality it is more than one step.
As a trust preferred holder one is a creditor of said company. As very junior creditor, but a creditor nonetheless. As a preferred stock holder, you are a part owner of the company. The differences in investor classes can be distinguished in terms of a small business.
Let's say "Joe" owns a small business. Joe needs money so I invest in his firm to the tune of a 10% investment. I now own 10% of Joe's company. A few months later, Joe needs more money so he gets a loan from the bank. Later that year, Joe's company is barely breaking even. He has a choice to pay me a distribution (dividend) of make payments on his bank loan. Obviously the bank gets paid instead of me. The bank is a creditor and deserves to be paid regardless of profitability. I am a part owner, I should only be paid out of profits. This is the big difference.
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