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Breaking: Fed Wants To Buy Your Debt

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A nationalized Fannie, Freddie to clean up mortgage mess.

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The Federal Reserve is one step closer to the direct purchase of bad mortgage debt.

In time, the Fed will orchestrate asset sales and writedowns for financial institutions at levels they can withstand while remaining solvent.

Professor Depew, Mr. Practical and others in the 'Ville have been covering the nationalization angle for a while now, and the Fed's actions yesterday provide additional fodder. In conjunction with new fiscal policies, the Fed plans to use government sponsored entities Fannie Mae (FNM) and Freddie Mac (FRE) to clean up the mortgage mess.

Fannie and Freddie will be charged with a problem that, for all its intricacies, is rather simple. Financial institutions around the world have too much bad mortgage debt on their balance sheets. Federal Reserve Chairman Ben Bernanke's solution is twofold, and involves more than just the elusive notion of nationalizing Fannie and Freddie: The Fed must balance protecting banks and bailing out homeowners, without ignoring moral hazard.

The financial system is a mess and embattled credit markets are preventing banks like Lehman Brothers (LEH) and Bear Stearns (BSC) from selling mortgage-backed securities.

Yesterday's announcement of the Term Securities Lending Facility, or TSFL, directly addresses this issue. The TSFL lets 28 primary dealers post AAA mortgage credit to borrow Treasuries.

Consumers, on the other hand, are staring down the barrel of resetting adjustable rate mortgages, falling home prices and a recession. Increasingly, borrowers are walking away from mortgages, and according to The Wall Street Journal, Goldman Sachs estimates as many as 30% of American mortgages could be upside down by year's end.

But the Fed can't just come out and announce it's going to start buying up delinquent mortgages; chaos would ensue. Already, many are criticizing the Fed's actions. Mike O'Rourke at BTIG had this to say:

"The Fed has moved beyond the realm of moral hazard monetary policy to tee ball monetary policy, where nobody loses. Don't get us wrong, we will be the first to say that the banking and financial system must be protected. We don't want to see the world fall apart. However, there must be a level of accountability for what has transpired."

Bernanke and the Fed are aware of the moral hazard debate and will operate behind-the- scenes to try to get the U.S. housing industry back on track. That starts with bringing home prices down to affordable levels and reducing delinquencies.

If Bernanke only had a couple multi-trillion mortgage conduits at his disposal to pick up the tab …

The Fiscal Stimulus package expanded Fannie and Freddie's role in the bailout of the mortgage industry, formalizing their de facto position as liquidity source of last resort. They'll eventually pick up the negative equity portion of upside down loans and bring home values back in line with affordibility. If this sounds far fetched, an excerpt from Fannie's 10-K should prove otherwise. This "loss mitigation strategy" is a delinquency bailout veiled as unsecured second liens for borrowers underwater on first mortgages, a fancy way of saying "principal writedowns."

The Hope Now Alliance will make certain that mortgage servicers can do pretty much whatever they want with delinquent loans, even though they're legally obligated to protect lenders and securities investors. Servicers will be able to refinance upside down borrowers since Fannie and Freddie will effectively reimburse banks for loan losses.

To implement all this, the Fed will need an operational mechanism to connect the dots. In the private sector this is called a "fund." In public circles it goes by the moniker "facility."

Imagine the first step in such a plan and you effectively have the Term Auction Facility, or TAF, which originally accepted a small amount of only the highest quality paper. The overwhelming demand for the TAF encouraged its expansion from Term Auction Facility to Permanent Auction Facility.

Yesterday's announcement to take on an additional $200 billion from securities dealers is the next step in expanding this program to include all mortgage debt.

A few token lambs will go under the knife of true nationalization, and if the Washington Mutual (WM) capital infusion rumors aren't true, some are predicting it may be the first to go.

Whether it's a collateralized debt obligation, mortgage-backed security or straightforward mortgage, the Fed's buying and everybody wins. Delinquency rates subside and banks write off bad debt at prices that won't put them under.

Everyone, that is, except the dollar. The actions described above are akin to the Fed tossing a few hundred billion dollars into a blender, which won't do much for our already struggling currency.

European policymakers are already concerned about the Euro's strength, and a further debased dollar may force the European Central Bank to lower rates just to cool off its own currency. The weak dollar trade is very crowded, and any inkling of a dovish policy shift in Europe could send the shorts for the exits and the dollar higher. The Fed would essentially be debasing the dollar into a rally.

How would this effect asset classes? Dollar devaluation versus. asset class inflation. Nationalization is deflationary, as the government burns up dollars to absorb the froth from inflated equity markets. The Fed is charting a methodical path in this direction, and yesterday was just the next step.

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