Wednesday, November 3, 2010

Free Lunch: Part IV

The Telegraph published an article today, The Bank of England must use QE to buy 'bad mortgages' warns  Fathom Consulting, that supports the "Free Lunch" idea discussed last week on this blog.

In the article, the consulting group makes the case for the Bank of England to fund a 'bad bank' to purchase the mortgages of households who can only make their debt payments because of near zero interest rates.  Whether there is an explicit bad bank set up or the Bank of England/Fed were to bring the mortgages/mortgage-backed securities on to its balance sheet, does not change the reliance on using the zero cost of funds to support the assets as a critical feature of the recommendation.  As discussed previously, it is the zero cost of funds that allows a central bank to fund the purchase of these assets at higher prices than other market participants, turnaround and offer the borrowers a modification that makes sense given the borrower's economic condition, and be able to do both without realizing a 'loss' if the borrowers ultimately pay enough through interest and principal to cover the purchase price.

The consulting group cites numerous benefits of taking this action including 1) freeing up monetary policy so that interest rates can be allowed to rise and 2) recapitalizing the banks so they are no longer constrained in their lending by the overhang of potential bad debt.

Finally, the consulting group claims that the idea is gaining traction with "Monetary Policy Committee members and other interested parties."

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