The Fed’s action caused financial markets to rally, because it could break the logjam that is causing the credit crunch. But the real problem is too much leverage in the system. To illustrate, let us say that Bank A makes a loan of $100,000. In order not to tie up its capital, it sells the loan to a Wall Street firm, such as Bear Stearns, so that it can make more loans. So far so good.
But Bear Stearns, instead of using its own capital to buy that mortgage, in fact only put up $1,000 of its own money and borrowed the rest--$99,000! It used borrowed money to buy borrowed money, in other words. This is the essence of the problem. So if the original $100,000 mortgage defaults, then Bear Stearns loses more than $100,000. It could lose up to $200,000, since it still owes the $99,000 it borrowed. This is a gross oversimplification, but you get the idea.
So until much of the debt that was run up since 2001 is either paid back or written off, the financial markets—and housing—won’t return to normal.
Meanwhile, running to the rescue are Fannie Mae (the Federal National Mortgage Association) and Freddie Mac (Federal Home Loan Mortgage Association). Purchasers of conforming loans, they now seem to have the only affordable loan programs at present, while rates on many of the jumbo loan programs are sky high.
Why? Because Fannie and Freddie have not lowered their underwriting standards and so still retain a AAA rating with investors, the same rating given to government-guaranteed Treasury bonds.
It does seem that housing is settling down in some parts of the country. February construction (housing starts) was up in California and the South, while builders’ sentiment tracked by the National Association of Home Builders has remained stable for 4 months. All eyes are on housing starts and new-home sales in the coming months, since they are an early indication of economic recovery.
"Our latest surveys of single-family builders reveal that many prospective buyers are looking into a home purchase at this time, but that they are unwilling or unable to make their move with conditions in the overall economy and financing arena what they are," said NAHB Chief Economist David Seiders.
Regionally, housing starts were unchanged for the month in the Midwest, up nearly 4 percent in the South and up 5.1 percent in the West, while the Northeast posted a 27.7 percent decline that offset a large boost in the previous month. However, every region was down on a quarterly basis in February.
"The Federal Reserve's latest moves to shore up financial markets have certainly been welcome developments, and a significant interest rate cut following today's FOMC meeting will be more positive news," Seiders said. "Beyond this, Congress and the Administration should follow up on the recently enacted economic stimulus package with additional measures aimed directly at boosting the housing market. If prompt action is taken in the direction of a home buyer tax credit, FHA modernization and GSE oversight reform, a housing recovery could take shape by this year's second half and the benefits of that to the overall economy would be substantial."
History will tell if the Fed’s actions will be enough to ease the credit crunch. Estimates of the costs vary for curing the credit crunch—from $200 to $400 billion. This will be about the same cost to taxpayers as the S&L bailout of the 1990s, when inflation is taken into account. So history will be repeating itself.