The Federal Reserve Regional Bank in San Francisco has come around to arguing for what I have been urging since 2008, pump up the credit supply to boost consumption and thus revive the economy. Even more to my point, the bank urges buying Mortgage Backed Securities (MBS) to do this. Egads, buy “toxic” assets?

I know it will be boring to rehash the fundamental errors made that led to the “Great Recession” but in order to understand it, and understand the SF Fed’s call, I will briefly restate the matter. Mortgage backed securities were the darling of all investors. However, the “MBS” were traded privately between willing sellers and willing buyers so there was no “open” market where one could see the values. In fact, the market was so closed no one had any idea of how large it was with estimates running into such unfathomable numbers as $100 trillion or almost seven times the US annual GDP. Needless to add no one had any idea of the nature of the market or who owned the bonds or who owned how much.

In the absence of any “market” by which to value these bonds, those trading in them used algorithms to assess them. And here was the fatal flaw, the algorithms were based on the housing market, i.e on the home represented by the mortgage, not the mortgage itself. The valuation of these bonds, which were constructed from collections of mortgages, should have assessed the risk of non-payment of the mortgages, not the value of the items purchased with them. For example, one values a bond issued by a company based on the earnings prospects of the company, not the value of the machinery and equipment purchased with the bond.

The bond raters compounded their error by mistakenly looking at the housing market as an “investment” market. They forgot that home purchases are first and foremost the purchase of shelter, a place to live, your anchor in an uncertain world, a place for your children to grow up, your refuge from the stress and strain of the world, your “castle.” Buying a home as an investment is a secondary concern. Of course the case is different for those who buy a home to use as a rental unit, i.e an investment. But that was the smaller share of the housing market.

So based on their algorithms geared to the housing market, not the mortgages themselves, and their view of home purchases as an investment, compounded by an incomplete idea of the size and nature of the market for mortgage backed securities, those rating the bonds started to lower their values. However, since there was no visible market, what started as a prudent course of action, very quickly turned to a race to the bottom, with some of these bonds devalued as much as 90%.

Since almost every financial institutions was heavily invested in mortgage backed securities the balance sheets of all quickly turned to liabilities greatly out of line with assets, e.g the mortgage backed securities. Remember, one man’s liability is another’s asset. Soon almost all banks were on paper, “bankrupt.” Enter the “Great Financial Meltdown” of 2008 and then the “Great Recession” of 2009.

Proof that the bond analysts had made a tragic mistake was clearly demonstrated by the foreclosure rates during the last six years. Remember, the correct way to value the mortgage backed securities would have been to assess the potential for their being repaid, not the value of the item purchased with the loan, i.e the house. And the risk is that of non-payment, which leads to foreclosures.

The foreclosure rate for the USA in 2006, 2007 and 2008 was essentially the same, about 2% of all mortgages ended in foreclosures. So the massive devaluation of the mortgage backed securities was grossly wrong. The foreclosure rate did double to 4% in 2009 due to the loss of some 8 million jobs caused by the “Great Recession,” which was set off by the bad valuations of the mortgage backed securities. In essence the bond raters created a “self fulfilling prophecy.” Even more relevant, the foreclosure rate in 2009 was the high point in foreclosures, since then it has dropped steadily. The actual observed fact is that the foreclosure rate is determined by unemployment, not the value of the housing market.

Apparently the San Franciso Federal Reserve Bank’s analysts have either read my blogs over these last 4 years or have independently come to the same realization, i.e mortgage backed securities are not inherently “toxic,” but faulty valuations of them are “lethal.” With this proper understanding of these securities they now urge buying them.

“Hold on,” you say, “what’s to prevent erroneous valuations of these bonds again?” Well we now have a better understanding of how to value them, but more importantly, the new 2300 page Dodd-Frank Act makes the trade in these securities transparent, thus those doing the valuations are better able to see the overall size of the market, its nature, who owns what, how much is being offered, how much is being bought and all the other signs that an open market gives for better understanding the value of the assets being sold.

Unfortunately the Dodd-Frank Act is burdened by much blather about protecting borrowers from predatory lending practices and in general creating an unneeded added “shield” for the “average” consumer against “evil” financial institutions. Borrowers already faced reams of documents with warnings and cautionary notes in taking out a mortgage. Adding to this jungle of information will not make it any easier for the borrower to follow what is happening, if he bothers to read any of it at all.

The essential goal of the Dodd-Frank Act was stated eloquently by Congressman Barney Frank himself, “we will make every financial transaction transparent.” This is why the financial community is so hostile toward the Act, a transparent market makes it hard for one investor to gain an advantage over the others. All are on a “level playing field.” What had been a behind closed doors, elaborate,complex, high risk , high stakes operation in which one could make a “killing,” has become a plain vanilla investment market.

So the San Francisco Federal Reserve Bank calls for once more buying mortgage backed securities, as I have argued like a “voice crying in the wilderness” for four years. Why is this important? Because as I have stated ad nausea, as have almost all other economists, the key to a revived economy and more job creation is increased demand. And the key to increased demand is increased credit. And mortgages constitute the largest single source of credit. Now do you understand?