Another Fix For The Addicted Equity Markets

Yesterday's surprise move by the Fed to purchase up to $200B of troubled mortgage-backed securities from its primary dealers gave equity markets the sort of news that makes them look like a drug addict on their latest fix. The S&P500 Index rose 3.7% in response to the news of help in the credit markets.


This morning's Wall Street Journal front-page article states,


"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.

Still, the Fed's efforts won't eliminate the root cause of the economy's problems: falling home prices and a mounting wave of mortgage defaults.


As collateral, the Fed will accept debt or mortgage-backed securities issued or guaranteed by Fannie and Freddie, also known as "agency" securities. It will also accept other residential-mortgage-backed securities, provided they are rated triple-A and not on watch for downgrade, though it didn't specify what type. Such "private label" securities have been especially difficult to trade, in part because the Fed doesn't accept them as collateral for ordinary money-market operations."


Of all the Fed actions of the past few months, and rate cuts extending back through last fall, I believe this one is very shrewd and probably will be productive.


As I wrote in this post yesterday, the current deleveraging-fire sale cycle of fixed income securities due to bank margin requirement increases has resulted in somewhat irrational temporary valuations on some fixed income instruments.


This move by the Fed is a very clever way of providing a floor under the prices of these assets in the marketplace. With participation by the primary dealers, whether directly or with paper purchased or taken as collateral from their customers, virtually any qualifying fixed income paper will immediately have a minimum price set in the market.


As such, this should stop much of the panic dumping of fixed income securities of still high quality which are not otherwise in a non-performing condition. In that regard, it's a good move for US financial markets and the economy in general.


What concerns me somewhat is the equity markets' reaction. I suppose I should remind myself that it is just a one-day move, not necessarily a trend. But I cannot help thinking that the index's and various individual equity's prices moved unsustainably higher based upon this surprise move by the Fed.


As the Journal article, and various pundits noted, it won't make US housing prices rise, or prevent mortgage defaults. But it will remove credit markets as another source of potential US economic weakness in the months to come.