Monetizing Foreclosures

Fannie Mae reports that their delinquent mortgages are up 163% compared to last year. The delinquency rate was 4.9% in October 2009 and only 1.8% in October 2008. What does this mean for the economy?

We all know that the US Treasury has poured money into all sorts of financial institutions including Fannie Mae, Freddie Mac, AIG, and a multitude of banks. Less well known are the Federal Reserve Bank purchases of Fannie & Freddie’s debt and the mortgage backed securities (MBS) they guarantee.

What happens to mortgages that are on the Fed’s balance sheet? The Fed can buy MBS’s with money they create out of nothing. MBS’s are simply bundled mortgages. So the result is that the Federal Reserve Bank owns a growing number of mortgages and they paid nothing for them.

The fact that the Fed paid nothing doesn’t mean the seller received nothing. On the contrary, the money created by the Fed is just as spendable as the money the Treasury borrows from China. But this situation intrigues me.

If the mortgages the Fed brought with nothing become worth nothing when the borrowers default what happens? Is the money the Fed created to buy the bad loans inflationary? Or, does it merely inflate to the same degree that the bad load deflates?

If a house and its mortgage were worth $1,000,000 last year but this year they are worth only $500,000 is it inflationary if the Fed buys the mortgage for $1,000,000 or is it anti-deflationary by $500,000?

What if on average the Fed pays $750,000 for a bundle of identical suspect mortgages and in the end only 10% of them default? Then the Fed has assets worth $900,000 per original mortgage contract. Is this then deflationary? How about if the Fed sells the mortgages for that $900,000 average price?

It seems like everything depends on how much the Fed pays and what real default rate results. No matter what they do they'll be wrong. The only way they can not distort the money supply (and therefore eventual inflation) is to sell the mortgages for the same total dollar amount they originally paid. But, if they do that either the buyer gets an instant windfall profit (if the mortgage value at the sale is more than the Fed paid) or the Fed fails to sell the mortgages (if the mortgage value at the sale is less than the Fed paid).

My head hurts. If the Fed must play with the money supply I think they should stick to buying and selling Treasury bonds. Then, at least, they would be giving nothing for nothing - the valuation being purely made up and in the eye of the beholder.

Quote of the Day
“The essence of Government is power; and power as it must be in human hands, will ever be liable to abuse.”
James Madison