Is There An ABS Exit Strategy?

Does the Federal Reserve have an exit strategy for its plan to lend billions to holders of securities backed by auto loans, student loans, credit card loans, or small business loans? The Fed is acting as if this is a temporary solution to what it views as a deviation from historical experience in the asset backed securities market. But once we get started down this road, will we ever be able to get off it?

There’s a serious risk that the Fed may have to keep this new lending facility in place forever. The Fed’s basic strategy is to inflate the ABS market beyond the levels the market deems appropriate. Once those asset prices are inflated, however, they will be valued on the balance sheets of banks and other financial institutions at the higher prices. Any move to end the facility would result in a huge devaluation or deleveraging.

It seems as if the Fed assumes it can engage in this asset inflation on a temporary basis because it assumes the market for ABS is experiencing an irrational, momentary depression due to risk aversion. That’s the same kind of assumption banks used to not write-down billions of assets for months and months. But why should we assume that the market for these things will come roaring back? Isn’t it safer to assume that the market prices reflect actual predictions of the financial performance of ABS?

What’s worse, it’s not clear that the Fed will be able to end the facility even if the market suddenly regains confidence in the performance of ABS. As pricing climbs with confidence, is the Fed going to send those values right back down by pulling away the subsidy for purchasing them?

Let’s assume the Fed really does plan for the subsidy for the ABS market to be only temporary. If this is the plan, wouldn’t buyers have to be insane to purchase assets they know will get crunched back down by the Fed? How do you book these things knowing that their prices are strongly dependent on a subsidy the Fed could pull away without warning?

Once again, it looks like the Bailout Boys have come up with another plan that may be unworkable.

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