Federal Reserve Illiquid Portfolios Full of Toxic Mortgage Securities

* Federal Reserve releases information on portfolios of Bear Stearns and AIG: As part of their part of the rescues of Bear Stearns and AIG, the Federal Reserve took on some illiquid portfolios. After 1.5 to 2 years of holding these assets, the Fed has finally released information on what is actually in these portfolios. In the press release, on the Federal Reserve Bank of NY’s website, the Fed claims that they were waiting for waivers of confidentiality to Bear Stearns, JP Morgan and AIG, to allow them to release this information. 


These portfolios contain much of what can be classified as distressed MBS debt, whose market value dropped through 2008 and finally bottomed about a year ago. The AIG portfolios contain alt-a and sub-prime MBS securities, and CDO’s. In the Bear Stearns portfolios, they own much in the way of CDO’s, CLO’s, many real estate loans, including those on Hilton Hotel properties, credit default on many of the same securities included in the portfolio (both long and short CDS), and agency MBS securities, many which appear to be IO/PO or inverse floater derivatives. It is literally a bouillabaisse of toxic mortgage securities. We all knew there was some crazy stuff in there, but the list is quite impressive in as much as these are mostly the types of toxic mortgage securities which have dropped precipitously in value over the last few years. From their very low market levels a year ago, many of these securities have increased by 25% to over 100% in value. Of course, a year ago, many securities were down between 50% and 90%, so the rebound in value does not exactly get them back to par. Nonetheless, these assets are not the type of assets which the Fed claims to own, nor should they ever had lent against them. In fact, one could argue that the Fed was over-reaching their powers by even touching these assets, especially if you were to try to value these assets in the heat of the financial crisis. 


The Fed’s ownership of these portfolios will go down in the history books as one of the many follies of the financial crisis. Of course, we have been witness to this on a real time basis, and everyone gave the Fed and the government the latitude to do what they should never been allowed to do. I present to you Exhibit 1, courtesy of the New York Fed.


* The new mortgage “principal forgiveness” plan – the administration announced a new twist to the help the homeowners plan. The new plan, which still has many details to be worked out, would encourage banks to forgive a certain amount of principal of underwater mortgages, and the government would subsidize some of this expense. The very bearish housing analyst, Laurie Goodman, who now hangs her hat at Amhearst Securities, is excited about the plan, inasmuch that it will keep some supply from hitting the market in short order. On the other side of the ledger, there is a nice opinion piece in today’s WSJ about how this is just another iteration in a long list of mostly in-effective programs. I tend to side with the opinion in the WSJ.


On the one hand, I have been saying for 2 years, that principal forgiveness is the way to go, if you want to modify any mortgage, since it will give the incentive to good, and well-healed borrowers to continue to make their payments and stay in their homes. Once a borrower gets so far under-water, even if they can afford the mortgage, or have enough money in the bank to pay it off, they will choose to default, and buy a comparable home in the same neighborhood. Here is a real example from someone I recently met:


“We live in Florida and a few years back, bought a nice home in a gated community for $350,000, and financed $300,000 of it with a first mortgage. Now homes in the same area are selling between $150,000 to $180,000. We have asked the bank for relief, but since we are current on our mortgage, they paid no attention to us. So we decided to stop making payments, and will see what the bank does now. We have the cash to purchase a comparable house on the same block in the $150,000 to $180,000 range.”


Okay sports fans, you tell me. What should be done? The bottom line is that there is not enough demand to support house prices at the levels which they were trading at in 2005. Government attempts to halt a slide in prices will not succeed, because the government is not bigger than the housing market. Ironically, the government has been doing much to inflate home prices for the better part of the last few decades, by virtue of the financing programs available through the GSE’s. Take this away, and home prices would get trashed. If the government did nothing to stop the slow bleed in housing prices, then prices would be bottoming now, and probably 20-40% lower than current levels. Instead we will have an overhang of supply which will stream into the market over the course of the next few years, which in turn will also prevent a rebound in the housing market. In other words, there is no way that government efforts will stop the inevitable; they are just altering the path in which this over supply of housing gets re-distributed.


To the extent that the government, at great expense, helps soften the blow of falling housing prices, you still have some amount of natural housing turnover which will weigh on the market. So even if you rescue someone from foreclosure for a certain length of time, these programs are just delaying the inevitable. The folks in support of these programs will tell you that the delay will help, since they expect the economy to be much stronger in a few years. For my two cents, I think the economy will not be stronger, but hopefully, and this is really weird saying this, but hopefully, inflation will be making a come-back and real estate will stay where it is in a sea of other rising asset values.


One of the statistics I like to follow is the home ownership percentage rate. From the start of this data series in 1965, to 1997, this rate fluctuated between 63% and 65%. This appears to be a nice equilibrium rate of ownership. Since 1997, as mortgage rates came down, and underwriting standards were relaxed, the home ownership rate rose to a peak of 69% in 2004 and 2005. Since then, the rate has been gradually dropping to 67.2% as of the end of 2009. But this is still well above the equilibrium levels of the pre-1997 era.  My general view of the situation is that until enough people are forced out of homes they really cannot afford, and the shadow supply of homes in trouble are flushed through the system and sold to new buyers, then housing will continue to languish. And that brings me back to the false hope for real estate which inflation would bring.