Thursday, August 16, 2007

Mortgage Market Woes: The Fed's Response

by Amy Lillard

This year has been a year of ups and downs for the housing market. In our continuing series, we chronicle news affecting the housing market and its major players.

On August 10 and August 13, central banks in key countries injected funds into their respective banking systems. The Federal Reserve injected a combined $92 billion into the federal banking system. Simultaneously, the Europeans added around 203 billion euros and the Japanese 600 billion yen. Smaller amounts have come from the central banks of Australia, Hong Kong, and Canda. This is the first time that American, European and Japanese central banks have taken action together since the aftermath of 9/11.

The goal was a coordinated effort to increase liquidity and stabilize the foreign exchange rate. Underneath this monetary need was a need to reassure global markets about the availabity of credit in the wake of fears stemming from the subprime collapse that has led to the beginnings of a severe credit crunch.

What does injecting cash into world banks accomplish?

• Reinstating lending: Injecting funds in the country’s cash supply means large banks and broker-dealers can confidently begin lending between one another again. This process was disrupted due a major change: "re-pricing of risk." Many economists say that risk has been inappropriately priced during our recent housing booms and lending craze. This was a major factor in the subprime mortgage explosion, where less-than-ideal borrowers were accepted by lenders without enough regard to the risk represented.

• Limiting effects of subprime implosion: The impact of the re-pricing of risk was first felt in a narrow segment of the economy – the subprime market. Risky borrowers delivered on a potential for defaulted loans, and the dominoes fell. It spread quickly from there to firms and funds dealing with debt. Now it's spread to a more general cross-section of the economy. Experts say the effects are still somewhat limited, and the Fed's efforts, combined with other world banks, will help keep the effects limited.

• Restoring market confidence: The purview of the Fed is beyond day-to-day stock market action. But their funds were an active effort to stave off a global financial crisis. This leads to more confidence, leading to positive market responses. More market volatility can be expected, but experts say that the probability of larger economic pain is lessened due to the central bank’s actions.

• Helping global economic stability: European and Japanese involvement in this funding of central banks is another thing that will stabilize markets and head off further damage, according to analysts. A remarkable development in risk and money investment over the past decades is the commingling of money worldwide. Global markets are strong, but are tied with the flow of money and risk in the U.S. So this global effort to reinstate market confidence will be crucial.

In the short-term future, the Federal Reserve and other central banks remain on alert to, watching the markets and gauging whether more funds should be infused into the economy. Their goal now and in the future is to ensure fallout from the subprime collapse stays limited.

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