Business | Opinion
Fed's latest action may not be enough for the crisis
Falling home prices and rising foreclosure rates keep the pressure on banks and their balance sheets.
- By Michael Mackenzie, Financial Times
- Published: 00:41 March 18, 2008
Like a demanding teacher, the report card from the markets says that the Federal Reserve must try harder.
The central bank's latest strategy for restoring a semblance of order to the fractured mortgage, credit and derivative markets is seen as a palliative at best. It is not an obvious cure for the underlying problem: the deteriorating US housing market and an economy either in, or flirting with, recession.
"The Fed's action is not a panacea, but it shows that it is focused on some of the problems in financial markets and is trying to address them," says Larry Kantor, head of research at Barclays Capital. "We will probably have to see some light at the end of the tunnel in the US housing market before we see a sustainable recovery in financial markets."
Falling home prices and rising foreclosure rates keep the pressure on banks and their balance sheets. With unemployment rising, lenders also face growing pressure from deteriorating car and credit card loans.
"We don't hold the view that this is the end," says Tom di Galoma, head of Treasury trading at Jefferies & Co. "Unemployment is going up and real estate is heading lower and we just don't know when this will level out."
The Fed plans to exchange up to $200 billion of US Treasuries that it currently holds for triple-A rated mortgages held by primary dealers for a period of 28 days. The dealers can then lend out the Treasuries in the repurchase market in exchange for cash and in theory alleviate their pressing balance sheet constraints.
The Fed hopes this will slow the spate of forced sales and margin calls seen in recent weeks. These have roiled markets as banks have tightened the noose on credit for hedge funds and other investors. "If the goal here is to stem forced liquidations of mortgage paper, then this should help for the time being, but it is unclear how much it helps anyone but dealers," says Stephen Stanley, chief economist at RBS Greenwich Capital. He made the point that the Fed's plan "certainly does not help if a firm's mortgage paper is not eligible as collateral because it is already encumbered by margin calls".
Then there is the small matter of the first auction not taking place until March 27. "The biggest drawback of the programme is that it will take several weeks to become fully phased in," says Lou Crandall, economist at Wrightson ICAP. "Ongoing capital constraints will prevent the market from responding as decisively as usual to the news until the new credit from the Fed actually hits the Street."
Until the auctions start, the Fed and markets face a nervous period. In particular, the new liquidity measures still mean that banks will carry the mortgages they lend in exchange for Treasuries on their balance sheets and face the risk of mark-to-market losses in the event that mortgages fall in value.
Whether the mortgages, interest rate swaps and credit markets can stay on the positive track and reduce long-term borrowing costs will be the real test. In spite of sharp Fed rate cuts, long-term mortgage and corporate bond rates have not fallen sharply amid the market turmoil and heightened volatility.
"The way to gauge a turn in a market is to watch for a deceleration in a trend," says Bill O'Donnell, strategist at UBS. "Simply, trends need to slow before they reverse." The Fed's move was "a solid step toward restoring even a modicum of confidence in markets that had recently become caught in the grips of the dreaded adverse feedback loop".
Others are not so sure that banks will ease the pressure on clients. "The announcement by the Fed could end up being a disappointment if pressure on the mortgage-backed securities market resumes and this step ends up pre-empting stronger moves that investors have increasingly been hoping for," says Ted Wieseman, economist at Morgan Stanley.
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