Enhanced liquidity?

Holman Jenkins:

America finally got its Northern Rock. The British mortgage lender made the error of relying on short-term borrowing in the capital markets to fund its mortgages for home buyers. Bear Stearns made the error in these skittish times of relying on short-term borrowing, in the form of overnight repo agreements, to finance its holdings of mortgage-related securities.

Result: Now Northern Rock is property of the British government, and Bear Stearns is property (pending lawsuits) of J.P. Morgan, as a stand-in for the U.S. Federal Reserve.

If it's true that temporary market chaos has grossly distorted the value of securitized mortgage debt, the Fed has fixed a sizeable part of the problem. It took $30 billion in potential losses on its own books, and even will manage the portfolio. If the optimists are right and those securities bounce back, J.P. Morgan will capture the upside. If not, the Fed will get stuck with the downside.

Citigroup et al. must be wondering: Why can't we get that deal?

Just conceivably Ben Bernanke has finally hit upon the magic formula for restoring confidence in securitized mortgage debt and trading will now resume. Speculators will come off the sidelines, convinced of the Fed's willingness to step up and prevent price-crashing fire sales by illiquid institutions. The central problem of the past eight months -- the fact that nobody was willing to take a flyer on a great deal of mortgage debt at any price -- will have been solved.

If so, demands for a taxpayer bailout will fade along with fears of a self-reinforcing spiral of falling home prices and borrowers walking away from $10 trillion in mortgage obligations.

Not an impossible forecast. Markets are rational: They can be relied upon to put a realistic value on America's outstanding housing-secured debt -- that is, as long as investors don't fear a cascade of forced sales by institutions desperate to raise cash at any cost to meet margin calls or regulatory capital standards.

After all, the dimensions of the challenge were never as unlimited as some made them sound. Even President Bush, judging by his rhetoric on Friday, seems to think the subprime crisis began because hard-pressed families no longer could afford their homes. Remember, we're not talking about unusual numbers of people who suddenly lost their jobs and no longer can make house payments they previously were able to afford -- the circumstance traditionally behind most foreclosures.

Employment was strong when the crisis started and continues (so far) to be quite decent. Yet the mortgage default rate has risen to about twice the average rate of recent decades, and the difference consists largely of people who contracted mortgages their incomes wouldn't support based on a bet that rising home values would bail them out.

More than a third of these new-look defaulters are absentee owners. Nearly half take off without communicating with their lenders. Mr. Bush is kidding himself if he thinks his fellow citizens share his view that these are needy victims.

...

I think predatory borrowers are probably a much bigger problem than predatory lenders. Lenders tend to be more rational than the predatory lender scenario would suggest. Why would a lender want to loan money to someone he knows will go into default and stick him with an asset worth less than he is owed. That make no sense at all.

The Fed's attempt at restoring liquidity to the mortgage market may work for a while, but it does not seem to address the fundamental problem of the mortgage backed securities market. These securities were supposed to enhance the liquidity in the mortgage market. It turns out they have done the very opposite. This raise the question of whether they important to have at all. They have enhanced volatility while not enhancing liquidity so what are they good for?