Fear and Greed Blog

Long time, no post.

Sorry about that. Life happens.

A lot has happened over the last month. I will attempt to add my point of view to the areas that I think are worthy of discussion. Please feel free to agree (or disagree) using the "Comments" link below.

I find the idea of a borrower bailout extremely interesting. I agree with Fed Vice Chairman Kohn's statement that the moral hazard related to acting is less of a problem than not acting and allowing innocent bystanders bear some portion of the cost.

What I find particularly interesting, however, is the part that fraud and sloppiness seems to have played in the sub-prime crisis.

Fitch put out a report entitled The Impact of Poor Underwriting Practices and Fraud in Subprime RMBS Performance (in case you were wondering, RMBS is an acronym for "Residential Mortgage Backed Securities)."

One source that they relied on in their analysis was a report put out by BasePoint Analytics, LLC. BasePoint's analysis found that up to 70% of mortgage early payment defaults can be linked to a significant misrepresentation on the original loan application.

Fitch conducted their own analysis using a very small sample of early defaults from 2006, many of which had what appeared to be strong credit characteristics. Fitch reviewed the loan files for the sample and found problems with more than half! Some of these problems were technical (borrower's balance sheet and income didn't support the level of stated income) and some of them were close to fraud (receiving credit for being "authorized" to use other people's credit - the credit agencies have stopped raising FICO scores for this method of "credit enhancement").

If fraud played such a large role in the current crisis, I don't think it's the borrowers that the government should be looking to bail out.

I suggest that you read the report if you find this subject at all interesting.

Given the potential cost to the US taxpayer, I would expect most US citizens to have some interest.

Earlier today, I wrote a commentary on the change in the Discount Rate in which I said I did not believe the change would matter very much.

I should clarify.

I do not believe that the cut will matter much in regard to the systemic problems we're seeing with structured products and risk aversion.

I do believe, however, that it was a masterful stroke.

The Federal Reserve is in a difficult position. If they cut interest rates, the dollar would likely drop, and inflation (which, even at current rates, is extremely difficult to maintain within the Fed's specified bands) would likely rise to unacceptable levels.

By lowering the Discount Rate, and easing some of the terms for borrowing from the District Banks, the Fed has, quite literally, stopped a run on the bank (Countrywide, in particular). I mentioned this in the earlier post, but I feel that I did not give the Fed enough credit for what they did.

Lowering the Discount Rate (which is still priced above the Fed Funds target) gives banks that have been experiencing larger than normal withdrawals, and limited availability of funds due to risk aversion (fear), to support both those withdrawals and their mandated capital requirements. The fear in this case, of course, is a fear of bank failures primarily related to the expected continuation and expansion of mortgage defaults).

Doing this, however, does not have the same effect that a cut in the Fed Funds target would have on overall short term rates. So no unusual inflation, etc.

In the near future, I will address why I do not believe that the Fed, or the Federal and State Governments, can do much to alleviate the situation without exposing tax payers to an expensive bail-out plan. A bail-out would be popular with some, but the actual cost, and the need for greater tax revenues, would create an extremely unpopular situation.