The Fed and the Subprime Crisis

Both the Fed and the European Central Bank are adding reserves to the banking system, but this is not a bailout.  At least, not necessarily.

We know there are some bad assets out there, primarily adjustable rate sub-prime mortgages.  Someone has to end up holding the bag.  Those someones will lose money, and I won’t shed any tears for them. 

In the meantime, some folks with sound mortgage backed securities are having trouble.  The underlying loans are just fine; these are the loans to good borrowers, who put 20 percent down and whose interest rate is fixed.  However, financial institutions cannot easily tell whose assets are good, and whose are bad, so they are being cautious about everyone who owns mortgage backed securities.

The central banks are stepping in to provide liquidity (extra bank reserves) so that companies or funds with sound investments don’t have to shut down simply because markets have not figured out which assets are good and which are bad.

Impact for the future:  I do NOT expect a macroeconomic impact from this event.  Garden variety businesses and consumers will go about their business, spending and producing goods and services.  No recession is likely.


Note:  why can’t financial institutions figure out the good assets from the bad?  The balance sheet label “Mortgage backed securities” covers an exceedingly wide range of mortgages, ranging from the very good to the very bad.  An analysis requires an analysis of every individual security in the portfolio, which is tedious and time consuming.