Rafi Mohammed

The Federal Reserve is Making a Mistake

Posted on August 23th, 2007 (0 Comments)

Admittedly, this blog is veering a bit off topic (we’ll get back to making everyone more money next week, I promise) – but the Fed is front page news and I think we should understand and question its actions.

As we all know, the shaky housing market and increasing mortgage defaults are hurting the economy. Investors are finally questioning the value of securities backed by mortgages – they are worried about defaults. As a result, investors are steering away from securities backed by mortgages - if they do invest, they are rightfully demanding higher interest rates. This is causing problems for companies like Countrywide, which is the nation’s largest mortgage broker. Here’s how mortgage brokers work: they make loans to homeowners and shortly thereafter, sell most of these loans off to investors. Before selling mortgages to investors, brokers need working capital to make loans. To obtain this working capital, they issue securities (often bought by money market funds) that use mortgages as collateral. Now investors are concerned about the quality of the mortgages used as collateral. Sounds reasonable to me. This is hurting companies like Countrywide.

In addition to mortgage brokers, what’s emerging is that entities like hedge funds and banks also hold mortgage backed securities. This limits their ability to obtain credit and exposes them to large default losses.

Last Friday, the Fed took two actions. First, it conveyed its concern about the economy and hinted interest rates may be lowered. In my opinion, this hope of an interest cut is what caused the market to rejoice with a 300+ point rise in the Dow Jones industrial average (check out this blog to better understand the benefits of lower rates). Second, the Fed welcomed banks (many mortgage brokers are affiliated with banks) to borrow money from the Fed at discounted rates and use mortgage backed securities as collateral. So while the market is worried about the quality of mortgage backed securities, the Fed in essence is turning a blind eye. Care to guess who will be left holding the bag if these securities head south?

I think the Fed should have let the market work. Guess what, “for profit” companies and investors made a mistake. As it turns out, interest only mortgages and 2/28 mortgages (that offer low teaser interest rates for 2 years and a much higher one – often resulting in a 30% increase in monthly payments – for the remaining 28 years) were bad business. When you and I make a poor financial decision (like the time I shorted eBay and lost my shirt), the government doesn’t bail us out. The market became irrational and everyone wants the party to keep going. Remember…even Paris Hilton had to pay for her poor judgment.

Now you’re going to see a massive lobbying effort for the Fed to lower interest rates. In part, a lower interest rate will reduce the risk of mortgage defaults, which will help wealthy investors in hedge funds like Goldman Sachs and KKR that hold these mortgage securities. Don’t get me wrong, as you know I love profits (admittedly…perhaps too much), but believe in making money by the rules. Since you and I don’t get to share in the upside of Gulfstream private jets and multi-million dollar Hampton homes, why should we have to bail out and cater to financial “gurus” that made bad bets?

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