Hurricane Lehman Update, 10 AM EST
By Arnold Kling
Floyd Norris writes (see the 10:10 AM post),
It may sound foolish to see an encouraging sign in the fact financial stocks are only down about 3.5 percent so far today. But it is encouraging.
I don’t think he’s foolish at all. I’d almost call it a “relief rally.”
Alex Tabarrok has a snarky comment on the Bear Stearns bailout. I’ll let you read it. Let’s just say that although bailing out Bear Stearns may not have been sufficient to prevent other firms from getting into trouble, it may have been necessary.
Deep in the bowels of Wall Street, there is something called the repo market. It used to be that Marcia Stigum’s The Money Market was the classic to read on this. I don’t know what people read today. Anyway, banks and Wall Street firms are constantly putting securities on repo. Suppose I own a five-year bond, and I want cash. I sell you the bond with an agreement that I will repurchase it in 7 days (or 14 days or 30 days). In effect, you are lending me cash, with the bond as collateral.
When a bond is considered safe enough, it can act as collateral in the repo market, and that makes it a very attractive asset. A year ago, it was easy to repo a bond backed by mortgages. Today, not so much. That is why credit markets have been looking sick.
What I’m guessing that the Fed is doing is making repo loans on mortgage-backed securities. By maintaining those securities as good collateral for repo, the Fed is keeping their value from falling. In that sense, it is being just as active with the Lehman bankruptcy as it was with the Bear Stearns bailout. Maybe more active, for all I know.
What everybody hopes is that a lot of the mortgage loans will continue to be paid. At some point, the securities that those loans are backing will stop being orphans that nobody wants to adopt. The outstanding balances on the securities will start to decline. Pension funds and college endowments will take them into their portfolios. And the crisis will be behind us.
If it plays out that way, then Ben Bernanke will look even better than General Petraeus.