The Fed's Potentially Very Bad Policy 16 comments
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Incoming data confirms that the economy slid into the heart of the recession in the fourth quarter. The ISM nonmanufacturing report posted a stunning decline in service sector activity. Like its manufacturing cousin, the underlying details were simply depressing, with the drop in the employment component setting the stage for a particularly week labor report later this week.
ADP reported a sharp drop in private employment in November; this report has been underestimating declines in recent months, suggesting the possibility of a blowout number. Auto sales fell off a cliff in November, and I doubt December is looking much better. The Beige Book provided grim anecdotal evidence consistent with the data.
Unfortunately, we will have more months of such data. With the economy already a year into recession, with the worst still ahead, not behind, policymakers will become increasingly desperate to do “something.” And that is exactly when some of the worst policy will evolve.
In the heat of the moment, we love crisis managers. But actions taken by crisis managers, who would argue that something just needs to be done, can yield very bad outcomes over the longer run. As much as I respect incoming administration members Timothy Geithner and Larry Summers, their efforts at crisis management during the Asian Financial Crisis left long lasting effects on the global financial system. During the Asian Financial Crisis, U.S. Treasury officials thought it best to use the IMF as a club to beat struggling economies into submission. As a result, foreign policymakers around the world thought it best to accumulate massive reserves that fundamentally altered the path of capital formation in order to make the IMF irrelevant.
Quietly watching while the U.S. current account deficit expanded validated the global perception of the U.S. as consumer of last resort and further aggravated global imbalances. And if you don’t believe those imbalances are at or near the heart of the current crisis, I urge you to read Brad Setser. Separately, the Federal Reserve in 1998 took on the job of financial market guardian with the LTCM unwind, thereby setting an expectation that the Fed would always prevent anything very bad from happening. But after taking on the responsibility, the Fed never followed through on oversight. Shouldn’t Citi’s (C) off-balance sheet entities have raised more questions?
In all honesty, I hold Geithner and Summers less to blame for the aftermath of the Asian Financial Crisis than the Federal Reserve. Arguably, they never had the chance to offset the negative outcomes of their crisis management efforts; the stage was soon taken over by the Bush Administration, which set about eviscerating Treasury. And it is to Geithner’s credit that while at the helm of the New York Federal Reserve he tried to get ahead of the challenges in the CDS market. Overall leadership at the Federal Reserve, however, should have worked to correct the moral hazard they infused into the financial system.
This is not to deny the importance of crisis management, but to point out that when the crisis is over, you need to be able to correct for the excesses of your actions. With that in mind, crisis managers need to be wary of taking actions that they cannot revoke when necessary.
Which brings me to the trial balloon Treasury floated today; leaking plans to stem the decline in the housing market:
The plan, which is in the development stage, would temporarily use the clout of mortgage giants Fannie Mae and Freddie Mac to encourage banks to lend at rates as low as 4.5%, more than a full point lower than prevailing rates for standard 30-year fixed-rate mortgages.
The key word here is “temporary,” implying a sunset clause. This is a program, however, that screams permanency. Once the federal government defines a right to low rate mortgages, they will find it very hard to reverse their position. (The Treasury may think they can make an arbitrage profit now, but just see what happens when the relative yields flip.) Why? Because at some point in the future, revoking the right will create classes of winners and losers, especially if it results in a steep rise in mortgage rates. And the losers will fight tooth and nail to prevent that rise; just imagine the army of lobbyists from home builders and realtors that will descent on Washington.
(Separately, Calculated Risk questions whether or not the Treasury can meaningfully impact housing prices via the rate mechanism.) Moreover, it seems difficult to imagine that this program can be limited to those buying a home; why should those seeking to refinance be excluded? Wanting to stay in your own home is something the government should discourage?
The Fed has already stepped onto this dangerous ground by announcing plans to bring down mortgage rates by buying agency debt in large quantities. A reversal would threaten their political independence (which perhaps was lost long ago). To be sure, the Fed has always altered interest rates as a tool of monetary policy, and rate increases have always drawn the ire of politicians.
But the Fed could always argue that the impact on home mortgages was simply an indirect consequence of their efforts to stem inflation in the economy as a whole. Now their actions are directly targeted at housing itself; they have announced they have the power to set mortgage rates. Politically, this is very different. At some point in the future, interest rates will need to rise, and I worry at that time the Fed will learn just how hard it is to taken away what Americans view as a God given right – government support for the housing market. Just think about trying to take away the home mortgage deduction.
Perhaps I worry too much. Perhaps it really will be temporary. Consider, however, who is behind this proposal:
The Treasury plan is similar to ideas previously floated by the National Association of Realtors and the lobby group for home builders...
I can only think of Adam Smith’s warning:
The proposal of any new law or regulation which comes from [businessmen], ought always to be listened to with great precaution, and ought never to be adopted till after having been long and carefully examined, not only with the most scrupulous, but with the most suspicious attention. It comes from an order of men, whose interest is never exactly the same with that of the public, who have generally an interest to deceive and even to oppress the public, and who accordingly have, upon many occasions, both deceived and oppressed it.
What is the alternative? Stop focusing on the housing market. Stick to policies that will be revocable when necessary. There are virtually unlimited opportunities for good policy in education, infrastructure, and health care, to name a few (Rebecca Wilder fears there may even be too many).
The Fed can support the economy, if necessary, by engaging in quantitative easing with unsterilized purchases of a set number of Treasuries on a weekly basis. This might partially monetize the deficit, but they can demonetize in the future. This maintains their position as supporting the economy as a whole, not a specific interest group. The latter is fraught with political dangers.
Final thought: Neither the Fed or Treasury would be in this position if the latter simply provided agency debt with the full backing of the U.S. government. Then when mortgage rates needed to rise at some point in the future, neither agency would have to take responsibility for the resulting damage to the housing market. Simple versus complicated.
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This article has 16 comments:
> jack
The argument against this is that it would make lenders more reluctant to provide mortgage debt and, consequently, mortgage interest rates would rise.
I think this argument against altering of mortgage terms in bankruptcy is undercut by the fact that the threat of altered terms in bankruptcy would have the effect of forcintg everyone in the financing chain to be more responsible. And, if everyone is more responsible, then the incidence of bankruptcy will decline, which means that there is less risk for lenders and mortgage rates should not increase.
The second argument against allowing mortgage terms to be altered in bankruptcy is that it will cut marginal borrowers out of the market.
But, it is in the national interest that respoonsible marginal borrowers obtain mortgage financing and we already have very successful federal and state run programs designed specifically for this purpose. This argument is just blowing smoke.
The argument for equal treatment before the law also favors the alteration of mortgage terms in bankruptcy. Well to do people can go bankrupt and have the terms of frivolous assets altered in bankruptcy. Marginal borrowers who may have no significant assets other than their homes cannot have the terms of their mortgages altered.
This is just another example of how our culture of rapacious and relatively capitalism favors the rich at the expense of the middle class and the poor.
The best way to level the playing field and restore responsibility to the mortgage lending market is to allow the alteration of mortgage terms in bankruptcy.
"For in every country in the world, I believe, the avarice and injustice of princes and sovereign states, abusing the confidence of their subjects, have by degrees diminished the real quantity of metal, which had been originally contained in their coins. ..... By means of these operations, the princes and sovereign states which performed them were enabled, in appearance, to pay their debts and to fulfil their engagements with a smaller quantity of silver than would otherwise have been requisite. It was indeed in appearance only; for their creditors were really defrauded of a part of what was due to them. All other debtors in the state were allowed the same privilege, and might pay with the same nominal sum of the new and debased coin whatever they had borrowed in the old. Such operations, therefore, have always proved favourable to the debtor, and ruinous to the creditor, and have sometimes produced a greater and more universal revolution in the fortunes of private persons, than could have been occasioned by a very great public calamity."
Still true, almost 250 years later!
> jack
corruption in the underwriting. 100%+ LTV (loan to value),
false documentation, false appraisals, unsustainable
debt service ratios- the lending end was a scam.
Lower rates are a positive but banks need to regulated, the
whole business became a scam.
20%-25% equity with real appraisals and real documentation
and lower debt service ratios would solve the whole problem.
Lower rates, lower property taxes, lower insurance costs are a
good thing for real world homebuyers. So it's all part of helping
affordibilty. The burden on the homeowner is much higher than
10 years ago, and don't forget about much higher maintenance
costs. Obviously people need a stable job market, and banks
need to be re-regulated big time. Deregulation via flipping and
massive over building are the primary culprits, not lower costs
of ownership for long term buyers.
Lower long term lending rates help the average homebuyer.
The housing market got corrupted through the lending
scam and a pyramid effect.
False appraisals, 100%+ financing, 50%+ debt service ratios,
falsified documentation- three to four years of it created the
bubble.
It's all about re-regulating the lender standards.
20%-25% down, real documentation, real appraisals,
lower debt ratios-
housing goes back to traditional buyers without the
massive corruption.
I'm all for lowering the burden on the homeowner-
owning a home is much costlier than 10 years ago-
real estate taxes, insurance, water, sewage, heating
and cooling, home maintenance-
dramatically higher. Less resources for more people
equal higher resource costs.
Moderate inflation in home prices helps
for a two or three years, but the ownership costs tend to
squeeze fixed income people out. The real winner is the
local government with a much higher tax base.
We should be questioning what "back on track" really means. Obviously, the previous financial order was untenable, so bailing out market participants who made bad decisions discourages systemic cleansing and restructuring, which is what is desperately needed.
If government must play a role it's best courses of action should be geared towards:
1) Conduct some DEEP soul searching...identify, and understand the BAD aspects of public policy that contributed towards this disaster, then take decisive actions to eliminate these policies, rather than creating new ones,
2) Smooth the natural process of de-leveraging...don't try to stop it, but focus on softening the pain that must occur,
3) Ensure all "smoothing" is equal and not targeted to some at the expense of others...government should not be creating economic winners and losers. A political-based economy is not an acceptable long run solution!
> jack
and be amazed at what a man with wisdom said 250 years ago. He speaks the truth. How much greater is the Truth of Jesus Christ who can in the name of love to save us all of our sins 2008 years ago. The Word of God is Truth. As a nation under God we are Blessed as was the intention of our Founding Fathers. Today, our nation runs toward iniquity and all forms of evil. Is it any wonder we are facing the trouble we have today? There is truely only one Way, Truth and The Life... Jesus Christ is Lord. Repent and Believe. May God continue to Bless our U.S.A Read: Malachi 3 & 4, John 3 & 4, Proverbs 1,2,3 & 4.