But the Federal Reserve’s introduction of a loan facility to support asset-backed securities backed by auto loans and other revolving-credit guarantees, along with a program to actually purchase mortgage-backed securities, may have finally altered the equation (where have we heard this before). In addition, the bailout of Citigroup, which contains a lifeline for $306 billion in troubled assets held by the bank, suggests to investors that the fundamental issues that have caused these problems — troubled assets held by banks, and reduced interest in lending in all forms — are being addressed.
“If you guarantee the debt outstanding, it’s almost the same as taking those assets off the books,” says David Reilly, director of portfolio strategy at Rydex Investments.
He said the government took a “circuitous route” to get to this point, first through expansion of the discount window, and later the original TARP plan, which was to buy troubled debts held by the major banks. Those didn’t do the trick. The Citigroup guarantee, he says, gives investors confidence that banks may begin to lend again — and raises the possibility that other institutions will see their problematic securities guaranteed.
Meanwhile, the Federal Reserve plan to buy up to $600 billion in mortgage-backed securities and agency debentures also boosted confidence. Spreads on debt issued by Fannie and Freddie, as well as mortgage-backed securities, contracted Tuesday.
“It’s a two-pronged program, designed to unfreeze credit and specifically to reduce the ultimate cost to homebuyers,” says David Albrycht, portfolio manager with Virtus Investment Partners’ Virtus Multi-Sector Short-Term Bond Fund. “Obviously by putting a bid out there they’re increasing prices and effectively reducing yields — the ultimate hope is that new origination will occur at lower levels.”
However, it’s easy to get excited about a plan when it’s first introduced. But the question remains whether these new programs will have a similar impact on the markets targeted as the Federal Reserve’s previous efforts to lower the London Interbank Offered Rate, or Libor.
This rate has fallen, but remains far above its historical difference with Treasurys, and the declines in Libor have been ineffectual in terms of jump-starting interbank lending, making this market largely a Fed-driven market. “Until people start lending and you start to see volume, it’s the actions of the Fed that are moving the market,” Mr. Albrycht says.
In addition, it’s also fair to ask just how much ammunition the Fed has left. The central bank will be increasing the size of its balance sheet with these purchases, and it has less than $500 billion or so in Treasurys left.
“Today’s action again begs the question: if the Fed and the Treasury are backing the U.S. financial system, who is backing the U.S.?” writes Tony Crescenzi, chief bond market strategist at Miller Tabak. “For now, investors are putting this question aside, and believing that such doomsday scenarios are a low probability.”