I thought I'd follow up my post from yesterday with an explanation of some of what is happening in the credit markets during the last two days.  Some people may have seen some headlines about the federal reserve injecting billions of dollars into the banking system along with ECB (European Central Bank), BOJ (Bank of Japan), etc.  More than likely this will get a lot more press in the main stream media this weekend, as the events are unfolding fairly rapidly.

To make a long, very complex story short...

Over the last several months the secondary market for mortgage backed securities (MBS) has deteriorated substantially.  Due to increasing default rates on mortgages it turns out these securities are worth much less than people thought.  For example many "AAA" rated MBS securities (the ones that are never supposed to have to have defaults) are going for 92 cents on the dollar.  This basically wipes out several years worth of interest for the investor.  Lower rated MBS are sometimes even turning out to be worthless due to the number of defaults.

Banks and other investors in the MBS's are now running into trouble because of what they thought were fairly secure assets have been loosing value rapidly.  Many times these investors have a significant amount of leverage which further compounds the losses.  For banks that must maintain a certain ratio of assets to the amount of money they loan out, a falling asset value can result in liquidity issues.  They can't lend out any more money.

What has happened in the last two days...

The overnight lending rate set by the FED, the one everybody pays attention to is 5.25%. This is the rate at which banks are SUPPOSED to lend to each other overnight to keep things running smoothly.  But yesterday banks started lending to each other significantly over this rate, it was up to 5.6% during the day and even went over 6% last night. Basically banks are pricing in the risk that someone large might go bankrupt within the next 24 hours.  Rumor is that a very large German bank which invested in MBS's is on the ropes and there are many people that believe one or more large US investment banks may also be in trouble.

This is the type of thing that can destabilize an global banking system, so the FED and various central banks have stepped in to provide temporary relief. The ECB injected around $80 billion dollars into their banking system yesterday and another $83 billion this morning.  The FED injected $16 billion yesterday and then made three more drops of liquidity today.  The BOJ did the same along with the Australian and Canadian central banks. 

This is not a bailout as it has to be paid back rather quickly, most of it will have to be paid back Monday. What it does do is it provides banks a chance to stabilize themselves, formalize a plan, and unwind investment positions in an orderly manner to free up funds. This is one of the main tasks of central banks, to keep the banking systems stable with added liquidity as needed.  The same types of liquidity injections took place in the LTCM hedge fund crisis back in 1998, in 2000 and after 9/11.  The size and how coordinated this action is by central banks indicates there is some fairly large disruptions going on underneath the surface, probably due to deteriorating value of mortgage backed securities.

So what's this mean for real estate and lending...

Pretty clearly this is going to speed up the tightening of lending standards and the availability of money to lend (higher mortgage rates).  The Fed, through their action is trying to make sure the machine doesn't totally seize up, but all of these events point to a significant repricing of risk.

Would a Fed rate cut help...

At this point a rate cut by the Fed would probably be much more damaging to the system than benificial.  It would signal a reduced confidence and possibly create a panic in the market.  Due to repricing of risk, mortgage rates and lending standards are beginning to tighten regardless of the fund rate or treasury prices and this is likely continue.  By damaging confidence in the markets this tightening would accelerate and you might end up seeing mortgage rates climb at the same time the fund rate drops.