Tuesday, March 11, 2008

$1 Trillion is the New Size 6!

"On March 7, Goldman Sachs economists published an even higher estimate of mortgage-related losses, at $500bn, along with $656bn in other losses, for a total of $1,156bn. The mainstream has caught up."

Unfortunately we have gotten to the point that we need to pray that the Fed can rescue the economy and financial markets. But as argued here last summer the problems in the financial markets are not just of illiquidity that Fed policy can address; they are rather of credit and insolvency that no amount of monetary easing and liquidity injections can ease.

Indeed, the reason why the agency debt and agency MBS securities spreads have sharply widened relative to Treasury has only partly to do with illiquidity; it has much more to do with the fact that Fannie and Freddie have already experienced massive losses on their portfolios of mortgage related assets and that these losses will significantly increase in the months to come. That repricing of AAA agency debt and agency MBS is a fundamental credit repricing, not just driven by illiquidity in these markets.

And now the Fed radically shifting the compositions of its almost $900 billion of assets from safe Treasuries into up to $400 billion of mortgage related securities is dangerous and a active form of manipulation of the credit spreads on these instruments. Why to fight a repricing of these agency spread that is fundamentally driven by the expected losses that the GSEs face? The last time the Fed tried to manipulate long term interest rates was during the Operation Twist program in the 1950s. The fact that the Fed has effectively gone back to trying to actively affect the yields on longer term (agency) bonds is a sign of how desperate the markets are now and how desperate the Fed has become in trying to avoid a financial meltdown that looks more likely by the day.