Monday, March 23, 2009

Trading in the mortgage market is off to a sluggish start this morning as investors direct their attention to the details of the Treasury's plan to set up public-private investment funds to buy up to $1 trillion in troubled loans and securities at the heart of the financial crisis.

Here's is a synopsis of how the plan will work.

· The Treasury will provide $75- to $100-billion to seed capital for public-private investment funds. These investment funds will combine taxpayer money with private capital. The investment funds are to be formed specifically to buy distressed loans from banks. The seed money the government will inject into these investment vehicles will come from the $700 billion financial rescue fund Congress approved last October.

· These investments funds will be able to use FDIC guaranteed debt to achieve a 6-1 debt-to-equity leverage ratio. That's a sweet deal. If private investors and the Treasury each contribute $1 billion to the investment fund, that entity can raise up to $12 billion in FDIC financing to purchase $14 billion in loans.

· Under this part of the program, banks would approach the FDIC with a pool of loans they want to sell. The FDIC would offer financing and the Treasury would partner with private investors to bid in organized auctions for the loans.

· Since the sale of these "toxic" assets will be made through a competitive auction progress (one investment fund bidding against the other) a market for loans and securities that otherwise could not be traded will be established. The competitive bidding process virtually assures the government will not pay to much as they help banks shed debt instruments that are severely limiting the banks available capital. The leverage offered by government financing to private investors ratchets up potential returns into double-digit ranges with minimal risk.

On its face, this is not a bad deal all the way around. The program will not likely become effective until late May, but the early reaction from investors around the globe indicates most believe the strategy outlined by the Treasury Department this morning might just work to revitalize the banking system. Since the details of the Treasury rescue plan were made public earlier this morning a handsome rally in the stock markets has developed - particularly in financial shares - as the prospects for economic growth ahead has now shown flickers of hope.

In other times mortgage investors might have responded to the hint of a future increase in the demand for capital (as banks take the first steps down the road to recovery) by nudging rates fractionally higher. Thank goodness the Fed is in the neighborhood with a fresh $750 billion in its back-pocket earmarked for the direct-purchase of mortgage-backed securities. Only a fool would try to trade against that kind of financial fire-power - and right now the Fed wants mortgage interest rates to remain near current levels.

The release of the February Existing Home Sales report was completely overshadowed by this morning's news events surrounding the Treasury's bank rescue plan. The National Association of Realtors said that existing home sales rose 5.1% last month - a much stronger performance than was expected. After a knee-jerk reaction related to the solid headline number -- mortgage investors shrugged the whole thing off when the details of the report revealed the sharp improvement in sales last month was largely created by significant price-cutting. Even with the sharp February sales gains the inventory of existing homes for sales rose by 5.2%. There is nothing here to suggest a bottom in the housing market has yet been reached.