RSSFRB Acts Free Up Bank Funds for Lending
The Federal Reserve Board stepped into the mortgage week this week to price and make a market for the collateralized debt obligations (CDO’s) that funded subprime mortgages. This could be what was needed to loosen the recent constraints on construction funding.
Banks thought CDO’s were short term investments when they acquired them but were stuck with them — unable to recover their money for other lending — when the CDO ratings from the bond rating services that has set their value and permitted trading proved to be vastly exaggerated.
The hundreds of billions of dollars of temporary liquidity injected into the market by the FRB and other central banks since early August permitted banks to continue near normal lending while they carried the suddenly illiquid mortgage back bonds. The resolution of the mortgage problem was postponed but not solved. The sharp plunge in short-term interest rates is evidence that banks hoarded the cash injections for fear of buying more overpriced mortgage backed assets.
The Temporary Auction Facility (TAF) initiated by the FRB this week permitted bank to use CDO’s and other high risk assets as collateral for $20 B in loans from the FRB. Normally, the FRB only accepts low risk government bonds as collateral. The $20 B amount is trivial compared to earlier cash injections into the banking system, such as the $500 B made available this week by the European Central Bank.
In the process of lending $20 B, the FRB priced the CDO’s, substituting for the failed rating services. The FRB expects that this unusual step will make a market for these assets so that banks can sell them and recover capital for other lending. That 93 banks offered collateral in the first auction, requesting $62 B in loans suggests that the TAF plan will have some success. Three more similar auctions are planned over the next month with other central banks planning similar coordinated actions to reestablish trading for CDO’s.
The consequence for construction are likely to be more funds and lower lending rates for jumbo residential, commercial and fixed rate subprime residential mortgages. There will be an accompanying boost to construction starts as some contracts will now be signed that had been held up by the buyers’ refusal to accept an unusually large rate premium. The outcome of the FRB action is still uncertain but looks promising with a positive impact on construction starts coming during the winter.
