Foreclosures tied to adjustable rate mortgages (ARMs) have led to problems for mortgage-backed securities (MBSs), which have necessitated a shoring up of capital by front-line financial institutions, despite the fact that MBSs have been largely “off balance sheet”.

Shoring up of capital is being accomplished in two ways:

(1) In several cases, sovereign wealth funds have come to the rescue. Sovereign wealth funds are large pools of money − acquired through energy earnings or an excess of exports − held by foreign governments. Three prime examples of recent bail-outs are:

a) The Abu Dhabi Investment Authority’s $7.5 billion investment in Citigroup Inc.;

b) Singapore’s Temasek Holdings Pte.’s $6.2 billion purchase of Merrill Lynch & Cos. assets; and

c) China Investment Corp’s acquisition of a $5 billion stake in Morgan Stanley.

However, this has not been a complete fix. The MBS problem is huge, probably amounting to trillions of dollars.

(2) A second move by the major financial institutions (hereafter referred to as the banks) has exacerbated liquidity problems. The banks have been reluctant to lend to anybody but the most creditworthy customers. In addition, they have been (in effect) calling in loans − or, perhaps more accurately, refusing to roll over existing loans.

To deal with this latest problem, the Federal Reserve, through its Term Securities Lending Facility, is making $200 billion in extra lending available to the banks (with nearly $50 billion more to come from foreign central banks). This will permit banks to borrow from the Fed using MBSs as security.

The money from the Fed can then be used to shore up lending to the second tier of shaky borrowers, often hedge funds or private equity funds. This will buy some more time while the default risks of existing debt instruments are sorted out and realigned. Plus, there is another consideration. Nobody wants the problems in the residential sector to spread to leveraged buy-outs (LBOs) in the corporate sector.

If the situation continues to deteriorate, there are at least two other steps that the Federal Reserve can take. First, it can buy MBSs from the banks. Nor would this be wildly irresponsible. Not all MBSs will default. Second, it can lend directly to non-banks. This was a course of action adopted in the Depression.

The Fed’s Chairman, Ben Bernanke, has also suggested one other possible fix. In the case of many mortgage foreclosures, the price of the house has now dropped below the value of the mortgage. As a result, some homeowners are simply mailing in their keys (“jingle” mail). It may simply be more advantageous to both banks and homeowners to renegotiate such mortgages by forgiving (i.e., reducing) some of the principal. The combines a degree of altruism with basic economics.

Alex Carrick

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