The Fed, The Congress, And the Treasury: Where to from Here?

We still have the same problem we have had for a long time; the real estate market is falling because there are so many foreclosures. We were hoping low mortgage rates would cure this problem. However, the mortgage rates are now rising again. The yield on the long bonds is rising. The 10 year note yield was 3.19% a month ago. It is 3.77% now. Other bonds have moved similarly. The mortgage rates have moved in virtual lockstep. The 30 yr fixed rate was down to 4.85% in April. Now it is at about 5.5% (last week 5.7%). The trend has definitely been upward lately. This does not help the real estate market. The supply of houses on the market temporarily went down, but this is likely only temporary. Plus the supply actually needs to go down much much more.

If the government does not find some way to stabilize the real estate market, the banks will need another bailout. The economy will fall further into the pit. Already the commercial paper market has been contracting dramatically again. Are we about to have another credit seizure as we did last fall? Perhaps we are!

What can the government do now? The Fed has tried buying mortgages to keep mortgage credit available and mortgage rates low. This has worked to some extent. However, the mortgage rates are still based on the long bond rate or the LIBOR. The Fed has tried buying bonds in an apparent attempt to keep bond yields down (or to ensure that the Treasury auctions are successful). This seemed to work at first. Now it is just being seen as monetizing debt (printing money). There is even talk of the US losing its AAA debt rating. The BRIC countries are talking about investing in each other’s debt as opposed to the US debt. What can the government do?

Bill Gross has said that the government probably needs to push the mortgage rates down to 3.5% to stop the fall in the housing prices. I don’t see how they can do this using their current strategies. The Fed Funds rate is already at 0% (since Dec. 2008). Monetizing debt results in devaluation of the dollar (inflation and higher long bond yields). That will not get us there, when the mortgage rates are being based on the bond yields. In fact the rising mortgage interest rates are starting to "slow" sales in the housing market. The government needs to take immediate action. What can they do?

One possible option would be for the government (Congress) to allocate money to fund low interest mortgage loans for the next two years (i.e. at 4% or even lower). This would likely get us past the huge crunch of balloon payment ARMs that are coming due in the next two years. This would allow the housing market to stabilize. Some individuals would benefit by being able to buy a home they could not previously afford. Some investors would get great deals, but they would also be doing the economy a great favor by taking houses off the market. The stability in the housing prices would help all of the banks. The equity for their loans would stop disappearing. The improved health of the banks would then help the commercial paper situation. Effectively this could start a reverse snowball effect. Help for the commercial real estate market would likely also have to be in the mix of the Congressional action.

I don’t contend that the above is the only option. I am eagerly awaiting the Fed announcement on Wednesday. I am hoping Mr. Bernanke et al have a positive surprise or two up their sleeves. I am just not sure what it is. Sometimes the simplest ideas are the best. If the real estate market is the root of most of the problems, it makes sense to take actions that will act most directly to cure that problem. A Congressionally subsidized interest rate would go a long way toward solving the real estate problems. It would help individuals get out of their mortgages. It would help other individuals to get into mortgages. It would help stop the huge bank foreclosure problem. It would help arrest the fall in real estate values. By helping banks indirectly, it might help them best. So far the government has tried to cure the economy by treating the symptoms (i.e. helping the big banks that were in trouble). Perhaps now it is time for the government to start treating the disease (the real estate markets).

Of course, I acknowledge that the Congress has already enacted legislation to help troubled homeowners. That has helped. Still it is likely not enough. They need to make the houses cheaper to own without causing a loss in equity, which will hurt the banks (and individuals) immeasurably. The only way I see to do this is to lower the mortgage rates. If doing this indirectly through the bond market or the Fed is not working, the Congress should probably take a more direct approach. Otherwise they may end up nationalizing the banks, etc. There will be a lot of pain associated with that.

I will eagerly await the outcome of the Fed meeting this week. I am hoping for some good news. Perhaps Mr. Bernanke has a few new wrinkles.

Comments

[Mad Hedge F...:]

The government can't rescue this market any more than they can cure cancer. Since I have been pelted daily with predictions that residential real estate has bottomed for the last 18 months, I feel a public duty to tell that is just not the case. Now that the state and federal moratoriums are off, foreclosures are accelerating. There are over a million Alt-A loan resets about to hit the fan. Since many owners will not see positive equity in their homes in their lifetimes, banks are seeing more walk always. The run up in mortgage rates from 4.5% to 5.5% has yet to hit the market. Some 18 million homeowners divert 50% of their incomes to pay for housing, double the 25% that is considered healthy, and many of them are losing jobs. While the volume of units sold has rebounded, the action is dominated by speculators, flippers, and bottom feeders bidding for properties at 10-40 cents on the dollar, not exactly a sign of health. Call me when Ozzie & Harriet Nelson come back to the market. I listen to industry insiders call the bottom of the Japanese real estate market for 15 years, until they finally died, and the market is still a fraction of its 1990 high. I thing we are closer to the bottom than the top in terms of price, but closer to the top than the bottom in terms of time. You can take that to the bank.

Jun 22 02:16 PM

[David White:]

Another possible scenario for solving the housing crisis might be for the Fed to become a landlord. Instead of just buying Treasuries, the Fed could buy homes outright. It could then rent them out for a number of years, so they did not just lose money. In this way the Fed could stop the downward spiral in prices. This would help individuals and banks. The Fed might even decide to keep some homes longer term as a tool. If the real estate market started overheating at some point in the future, the Fed could then start to sell off some of its stock of houses. This might actually help the Fed to manage the economy better. Plus it would not be seen to be as bad as buying Treasuries. This is seen as monetizing debt. The houses would actually be real assets. Plus buying the houses would accomplish a lot of what the Fed wants to accomplish.

Of course, this would necessitate a certain amount of infrastructure build in the Fed to manage this. However, it is actually workable. Likely it would have to be limited to the larger metropolitan areas (just so it is manageable), but it could actually work.

Jun 22 04:31 PM