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The Next Credit Bubble Is Now

Bubbles
Bubbles

Mortgage-backed securities—and the bankers who loved them—wreaked havoc last year, helping to pitch us into the deepest downturn since the Great Depression. Are you ready for a replay?

Gird your loins. The signs are growing that there's a new Wall Street gold rush under way—for those complex bundles of mortgage loans that fueled banks' profits between 2005 and 2007. This year, prices for mortgage-backed securities are rocketing as federal stimulus dollars flood the market. But the difference with this "boom" is the center of gravity has shifted: from giddy, cowboy bankers to the Federal Reserve. The Fed is so eager to save banks, create a demand for these securities, and stabilize the housing market that it's taking troubled loans and mortgages onto its own books. The problem is the Fed may be in well over its head.

The Fed is cleaning up the old mortgage securities in the market—mostly old residential mortgage loans backed by Fannie Mae and Freddie Mac. But it will soon be on the hook for new ones, too, as troubled commercial mortgages are expected to fail en masse in a crash. The institution has already received $2.3 billion in requests to buy commercial mortgages. Indeed, investors are so eager to dump their commercial mortgage-backed securities on the Fed that they have spurred an outcry against Standard & Poor's, which has said it may tighten its ratings requirements to keep the more problematic loans out of government hands. Put simply, the holders of such securities don't want anything to stand in the way of getting on the federal gravy train.

Both types of assets are creating a shadow boom in unworthy debt, based on the same excessive leverage and questionable financial judgment of the last credit bubble. Plus the Fed is making some of the same mistakes as banks did in 2005-07. The banks forgot they were in the "moving" business-of underwriting mortgage-backed securities—and got into the "storage" business of keeping those securities on their books. That's where the Fed is now. It has not yet articulated an exit strategy to dump up to $800 billion of mortgages from its balance sheet.

And if you thought U.S. banks holding all those sketchy mortgages was a bad idea, wait until you see what happens when the center of our country's money supply is saddled with bad debt. The Fed could bail out the banks; no one can bail the Fed out.

It's partly a matter of sheer dollars. The Fed has dug itself in deep, spending $64 billion over the last four weeks and $741 billion this year as it plans to purchase $1.25 trillion of securities backed by agencies like Fannie Mae and Freddie Mac .

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At the same time, prices for some residential mortgage-backed securities have jumped 40 percent or more this year to as high as 85 cents on the dollar, even though 9.24 percent of all U.S. mortgages are now delinquent. Analysts have warned that mortgage prices are overvalued. And when about one in every nine is heading for delinquency, buyers have to question the quality of all the bundles they are buying, no matter how highly rated. That is especially true as fewer and fewer homeowners manage to catch up on missed payments. Fitch Ratings, for instance, found that only 6.6 percent of homeowners holding prime loans managed to catch up on late payments as of July. As the Wall Street Journal noted, "That compares to an average of 45% for the years 2000 through 2006."

While the mortgage market is getting worse, the Fed is getting in deeper. In fact, the Fed never owned a Fannie-or-Freddie-backed mortgage before 2009 and now controls about 15 percent of that market, according to Credit Suisse (CS). No wonder Fannie and Freddie shares pitched precipitously upwards in Monday trading, by as much as 50 percent.. Perhaps investors are getting wise that the agencies are in for a long and very lucrative ride as the federal government supports their debt.

Plus, the Fed's buying spree has attracted the attention of investors looking to cash out on mortgage-backed securities: Everyone from Beijing to veteran investors is getting in on the action. Financial firms are forming real estate investment trusts—or pools of capital that buy mortgages-to buy distressed mortgages fast. Investors like hedge fund Third Point entered the market with a $160 million investment in the second quarter and quickly made a $20 million profit. John Costas, a former UBS employee who founded a fund that nearly took down the Swiss bank with bets on subprime mortgages, has just started a new firm to trade mortgages again. Of course, what Wall Street wants is a replay of the early 1990s, when savvy buyers of troubled mortgage-backed securities made a fortune by holding onto the toxic assets until the market came roaring back.

But the Fed should be driving a harder bargain instead of paying richly enough to create a boom. Not surprisingly, the hype for mortgage-backed securities is all in classic bubble language: Wall Street is just happy to have some business to do. Analysts goad on "vulture" investors in distressed mortgage securities by predicting returns of "several hundred percent" for savvy buyers who jump into the market now. Like many bubbles, however, those returns won't last forever. Eventually, supply and demand will fall out of whack again.

If the Fed wants to save banks and consumers by buying these securities, Wall Street is happy to play along. This boom will be hard to stop—and impossible to regulate—because it is spurred by the Fed. On the surface, everyone wins: Banks get to dump some bad assets and gain fees for selling them to the Fed. The Fed gets to enact a stimulus that helps the banks and gets the mortgage markets moving. Politicians can be delighted that Fannie and Freddie are getting some love, because they lend to consumers and that in turn wins votes. But, as we found out during the last boom, something that feels great at first can feel terrible later.