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QE3 and Mortgage-Backed Securities - Bernanke's Latest Folly

Updated on October 16, 2013

Quantitative Easing, Round 3


The news today is that the Fed will go forward with QE3. Their brilliant plan? Buying up $40 billion of mortgage-backed securities per month. They think this will somehow stimulate the real estate market, and even address unemployment, which is puzzling to me. The only thing the government is going to improve by buying up MBS's is the MBS market, and it was a hot MBS market that led to the housing collapse in the first place.

Some Background on Mortgage-Backed Securities


Simply put, mortgage-backed securities (MBS's) are financial instruments made up of bundles of home mortgages, which give the owners of those instruments the right to the cash they generate (your mortgage payments).

While mortgages have always been transferable, generally banks (and other lending institutions) used to loan you money for your house, then hold onto the mortgage and profit from the interest on your timely mortgage payments. As holders of your mortgage, they also took the risk of you defaulting, so before they loaned you that money, they checked you and your property out pretty well. It was a good system. Sometimes, you even had enough of a relationship with your bank that you could talk with somebody face-to-face if you had a problem.

Now, most mortgages are sold - immediately - for an instant profit. Mortgage brokers have a distinct set of metrics, laid out by whatever bank is buying the mortgage, that they need to meet in order to get a sale approved. For example, if a potential buyer applies for a mortgage at a brokerage, he/she must clear some hurdles: employed at the same job for x number of months; net income/debt ratio of y, minimum credit score of z , property appraised for a, etc... once all of the requirements have been checked off, the broker gets a promise from the bank, and buyer gets his mortgage. The broker immediately sells that mortgage to the bank, gets his money, and he is no longer on the hook. The bank now owns your mortgage.... for the moment, anyway.

If your mortgage is like most, the bank packages it into a bundled security (MBS), and that security is again sold. Now, that purchaser holds your mortgage. Could be another bank, could be an investor, or it could be a bank/investor from overseas. It doesn't matter too much - as long as you make your payments, everything is fine. (Usually, a third institution would collect your payments and pass them on.)

The Problem With a Hot MBS Market


Investors really liked MBS's. They gave great returns, plus they were backed by real estate. Investors like them so much that there was more demand for these MBS's than supply. And that's when things got sloppy (or fraudulent, take your pick). The demand for more MBS's was coming from investors, who aren't really interested in the details of what they are investing in. They look at rates of return and the investment ratings, then decide if that's a good investment or not, so they rely heavily on ratings companies like Moody's and Standard & Poor's to do the work for them. But those companies failed them - miserably. Somehow, MBS's made up of substandard loans were highly rated, which misled investors. (I'll leave it up to you to decide whether the ratings agencies were stupid or corrupt.)

In a hot market, when investors are clamoring for more MBS's, banks needed more mortgage loans to package up. So standards went down, corners were cut, and plenty of outright fraud was committed. One common category of fraud was bad property appraisals. Everything depends on an accurate appraisal of a property, since the mortgage loan is secured, ultimately, by the value of the property itself. If an appraisal is inflated, part of a mortgage loan is going to be completely unsecured (value of the mortgage - actual value of the property). Another common shortcut (or area of fraud) - fudging the numbers of/not fully vetting home purchasers. People who had no business getting loans were getting loans. It was an underregulated mess, but while home values were going up, few people noticed or cared.

Anyway, I'm not here to get into MBS's in painstaking detail. Suffice it to say that high demand from investors led to lowered standards (and fraud) in the mortgage business, which contributed to the ensuing high rate of default, which led to the housing collapse.

So why on Earth would Bernanke take steps to artificially re-heat the MBS market?

The Real Problem


People are still broke. Unemployment is still high, and those with jobs are feeling less secure about their employment. Who do they think is going to buy houses under those conditions? Rates are already incredibly low - if you can't afford a house today, you can't afford a house. The main difference between getting a mortgage now and getting one ten years ago is that now, banks again want 20% down. That is a legitimate hurdle, but it's also a safety feature for the holder of your mortgage.

The housing market isn't going to fully recover until people on the low end have money again. That is where the government should be putting its dollars - into the hands of the poor.

You would think Mr. Bernanke would know better by now that quantitative easing is a waste of time. After all, he's already tried, and failed, twice to stimulate the economy by pushing cash into the hands of banks. Has something fundamental changed in the interim that would make this work now?

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    • JohnfrmCleveland profile image
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      John 5 years ago from Cleveland, OH

      mio cid, thank you for your comment.

      I'm not so sure about that. Too many people just look upon QE as another expenditure that goes to the banks, and that's not a very popular idea among anybody but bankers.

    • mio cid profile image

      mio cid 5 years ago from Uruguay

      I don't know what long term effect they will have but they will sure help obama to be reelected.

    • JohnfrmCleveland profile image
      Author

      John 5 years ago from Cleveland, OH

      ib radmasters, thank you for your comment.

      I do think Bernanke is under some pressure to do something, even if he's putting it on himself. There really isn't much you can do for an economy with monetary policy - low interest rates are nice, but you can't force banks to loan money to people who simply aren't creditworthy. I have to give him credit, though, for finding a way to make waves with monetary policy, even if it is going to end badly.

    • JohnfrmCleveland profile image
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      John 5 years ago from Cleveland, OH

      Chris57, thank you for your comment.

      While I don't think it has anything to do with QE, you have hit upon something that I am planning to write about soon. MMT logic states that there must be deficit spending (new dollars created) to account for the dollars lost to savings, otherwise the number of dollars in the economy would steadily decrease, leading to deflation, contraction of production, etc. And savings accounts for those dollars held, both foreign and domestic.

      The saved dollars ultimately end up in the form of government bonds, where they really have no further effect on the economy. It makes no difference whether they are held by Americans, Chinese, or Germans - since the overall pile of saved dollars (the nationsl debt) never gets any smaller, those dollars remain sequestered, out of circulation, never to be spent again.

    • CHRIS57 profile image

      CHRIS57 5 years ago from Northern Germany

      This makes sense to me, not necessarily the monetary action itself but the 40 Billion per month. Over the year that adds up to almost 500 billion.

      Now - if you take a look from the outside at the US economy, then this amount of money is pretty much the current account deficit. So by issueing new USD the US economy just hands out enough money to cover the trade and current account deficit. Basically that is what has been happening ever after day zero after Lehman: all public debt increase was being matched by foreign bond aquisition.

      The US is free to print money, but only at cost of gradual loss of trust, trust into the solid value of the Dollar.

    • ib radmasters profile image

      ib radmasters 5 years ago from Southern California

      John

      Great article.

      Bernanke is the problem, and he has been one.

      The MBS is the same fuel that was used in the dot com the material was different but the mechanism was the same.

      In the dot com it was the stock market the loosened the traditional trading and its conservative investing. The dot com were Internet Stocks that couldn't have made it as a penny stock. I suspect that some newly degreed MBAs came on the scene and found the way to get their fortune fast. It helped that investors didn't have to have a broker mentor, just the broker house.

      These stocks had no intrinsic value at all. They were new companies, many only had an idea, and most didn't have a product, the ones that did have a product didn't have it ready to go, and those that had a real product didn't have an experienced business team.

      The idea like the housing bubble was to create the demand, let the investor believe that the gravy train was leaving the station, and they needed to get on. This worked the stocks spiraled up based on nothing but the hype, and the ticker value continuing to go up.

      The housing bubble is the same basic idea, market value is artificially being pushed up as more people get home loans, many can't afford them. The Fannie and Freddie encourage loans that don't have equity in them. Market appraisal is non existent, it is based on what ever the loan company will OK. you know the rest.

      The bottom line on both of these scams was a departure from conservative tradition investing standards. The Federal Reserve Board kept the loan rates real low, and didn't increase them. Had they increased the loan rates on the variable loans they loans would have failed earlier than the seven years that it did take to fail.

      The type of loans that were being financed were criminal, they were no better than interest only, and many were negative amortizations. Then they compounded it as you say with the MBS. You shouldn't even buy produced in the market when it is bundled. That is a sure sign that something is wrong.

      It is like FIAT money as long as their are people willing to take it there is no problem.

      Prior to the housing scam, FHA loans and Private Loans always required a substantial down payment because that was the protection for the bank. PMI was demanded if you didn't put down a large enough payment.

      Additionally, market appraisals were loan when the bank appraised property, compared to private market appraisals. I always thought that market appraisals were too subjective to be worthwhile, after all the real estate mantra has always been location, location, location. So how do you compare property that is across town?

      Thanks

    • JohnfrmCleveland profile image
      Author

      John 5 years ago from Cleveland, OH

      Attikos, thank you for your comment.

      I don't think it's as bad as all that. The government isn't spending money it doesn't have, not only because it always has access to more dollars, but because it's an asset swap. The government is trading dollars for MBS's, and while I'd much rather hold dollars, the MBS's still have value, and most (if not all) of the government's money will eventually come back to them as the MBS's mature.

      Also, simply creating dollars does not necessarily lead to inflation, so that is not a worry of mine, either. The truly disappointing thing about QE is that the Bernankes of the world still do not seem to understand how money works.

    • Attikos profile image

      Attikos 5 years ago from East Cackalacky

      I suspect Bernanke and the Fed board don't know what else to do, and the pressure to do something has grown irresistible. This is like putting bets onto the roulette table and praying your number eventually comes up, except that the FRB can stake itself with its magic keyboard. It will politicize the Fed, marking the beginning of its end as a viable central bank; put more phoney money into the banking system, which since neither business nor consumer is borrowing will find its way to the Treasury department to make it easier for the federal government to continue spending money it doesn't have; lead to the revival of the subprime lending disaster; bloat the Fed's already staggeringly huge balance sheet; inflate the US dollar by half a trillion annually. It would be hard for a writer of political fiction to imagine a plot more insane than this crazy scheme.