The central bank is keen to see people spending, for without consumption, the US economy is nothing
“You know, these days something or the other keeps happening before I have figured out what went before,” she said rather excitedly over the phone.
“Now what?” I asked.
“It seems you haven’t read the newspapers today. The United States government has announced another bailout, this time for $800 billion.”
“This isn’t exactly a bailout,” I protested. “Besides, it is the US Federal Reserve, the central bank of the US, which has made the announcement and not the US government.”
“It’s one and the same thing, isn’t it?”
“Not really. If the US government had to spend the money, it would need approval from both Senate and the Congress,” I explained.
“And how is it not a bailout?”
“Since this is going to be a rather long discussion, we will get back to that.”
“Okay. But what is this $800 billion going to be used for?”
“Good question. Around $600 billion will be used to support the big housing finance companies in the US and the remaining $200 billion will be used to support recently originated consumer and small business loans,” I said.
“That’s rather vague,” she said.
“Okay. Let me get into some detail. Of the total amount, up to $500 billion will be used to buy up mortgage backed securities, which are backed by housing-related government-sponsored enterprises (GSEs) — Fannie Mae, Freddie Mac, and Ginnie Mae. Through this, the government hopes to revive home loan lending by banks in the US. As you would know, home loans are referred to as the mortgages in the US.”
“I didn’t get that,” she interrupted.
“Let’s go back to the basics of securitisation. Banks first give out home loans to borrowers. Then they agglomerate similar loans together and convert them into financial securities. These financial securities are sold to investors willing to buy them. Once the securities are sold, the major part of the equated monthly installment that the borrower pays to repay the home loan is passed on to the investors who have bought these financial securities. This entire process is referred to as securitisation. Once a bank sells these securities, the risk does not remain on its books. Also, the money comes back immediately and the bank can give out more loans.”
“I know, you have told me that before.”
“I have, but have patience. The GSEs — Fannie Mae, Freddie Mac, and Ginnie Mae — were major buyers of these financial securities or mortgage backed securities. They provided liquidity to the entire market. Since they kept buying these securities, banks got their money back upfront and could go out and give more home loans. That’s how it worked until borrowers who had been given loans way beyond their repayment capacity started to default on their loans. That killed the securitisation market. Investors who once clamoured for these securities did not want to touch them at all. And once this happened, banks could not simply securitise their risk away and this made them more than cautious while giving out home loans. Also, since they couldn’t securitise, the number of loans made reduced significantly.”
“Are you suggesting that the Fed is trying to revive the securitisation market and thereby the housing market?”
“Yes. The Fed plans to appoint asset managers to buy mortgage backed securities. This will put more money in the hands of GSEs, so they can buy mortgage backed securities from the banks issuing them. Thus, the banks will get their money back upfront and can make more home loans, which in turn is expected to provide some support to the housing market that has gone into free fall.”
“How does that help?”
“As the house prices have fallen, a lot of loans are in negative equity. Negative equity is a situation in which the home loan outstanding at any point of time is greater than the market value of the house. Let us say the loan outstanding at this point of time is $250,000 and the market value of the house has fallen to $200,000, then there is a negative equity of $50,000. The bank that has given the loan is not into charity. At any point of time, they would like to ensure that value of the house, which is the collateral they have, is greater than the loan outstanding. If that is not the case, they would want the borrower to make up the difference. So, in this case, the borrower would have to pay the bank $50,000. But if the borrower is not in a position to pay, he might just choose to default on the home loan. In the US, home loans are non-recourse loans, i.e. the lender can seize only the collateral; the lender cannot go beyond the collateral and seize other assets or money in the bank account. The borrower is not personally liable for it. Hence, there is all the more incentive to default. Also, every time a borrower defaults, the bank seizes the house and puts it up for sale. This adds to the housing prices going down even further.”
“Hmmm. So the idea is to somehow stabilise housing prices and ensure that the number of defaults does not rise…”
“Yes,” I said.
“But what happens to the remaining $300 billion?” she asked.
“Of this, the Fed plans to buy up to $100 billion of debt issued by the three GSEs. That leaves us with $200 billion. This money will come from the Federal Reserve of New York, and will be used to buy recently originated top rated asset backed securities based on student loans, auto loans, credit card loans and small business loans. As with home loans, the other loans can also be securitised. And as has been the case with mortgage backed securities, there are few buyers for asset backed securities as well, giving very little incentive to banks to make these loans. Once the Federal Reserve of New York starts buying these securities, it is expected that banks will make more student, auto and credit card loans, in the same way as they are expected to make more home loans. Also, with the securitisation market picking up, interest rates being charged on loans are expected to come down, because the risk for the banks giving these loans will also come down.”
“In effect then, the Fed is trying to get Americans to start borrowing again?”
“You got that right.”
“But didn’t their borrowing binge cause these huge problems in the first place?”
“Yes it did. But remember that nearly 70% of the US GDP comes from private consumption. So, if people stop borrowing altogether, the economy can get into a recession, even a depression for that matter.”
“But where will all the money come from?” she asked.
“The Fed hasn’t said that yet. There has been no talk about increased borrowing. Neither has the US government talked about raising income tax. So, in all probability, the Fed will print all this money.”
“Will that help?”
“I wish I knew. Right now, the major problem is that banks don’t trust anybody. They don’t trust other banks, they don’t trust borrowers and they don’t trust prospective borrowers.”
“And why did you say it’s not a bailout?”
“Well, the Fed is buying mortgage-backed securities and asset backed securities in the hope that the borrowers will keep repaying their loans and over a period of time, it will get back its money. “Hope” is the keyword here, and there is a chance it could end up being yet another bailout.”
(The example is hypothetical)
k_vivek@dnaindia.net
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