In a series of articles I have been suggesting to readers ideas regarding what the Fed might do to tackle the current financial and economic crisis faced by the U.S. One of the main objectives of these articles has been to show that, contrary to widespread belief, the Fed has many potential “tricks up its sleeve” that could have a major impact on the economy and financial markets.
For example, I have evaluated the possibility that the Fed might lower the rate of interest it pays on reserves deposited at the Fed. I considered the prospects for an “Operation Twist.” I presented the Fed’s full “deflation tool kit” as described by Ben Bernanke in a speech in 2002. I described a policy proposal called “nominal GDP targeting” that could provide the institutional framework for implementing the Fed’s full took kit.
Today, I will present the most radical idea I have yet analyzed. Having said that, in an emergency, it could prove to be an economically effective and politically viable alternative. The idea consists of forming a partnership between the Fed and private banks in order to provide support for middle and lower class mortgage-holders in the United States.
This proposal would put money in people’s pockets that they would in turn spend on goods and services thereby providing stimulus to the economy. In addition, the moderately inflationary consequences of such a policy would go a long way toward deleveraging balance sheets in America’s most indebted sector - the household sector and lower and middle income households in particular.
Tackling America's Housing Problem
The idea is extremely simple.
Currently there is roughly $10 trillion of home mortgage debt in the U.S. The average home mortgage value is in the neighborhood of $200,000.
The Fed would institute a program providing an unlimited quantity of long-term funding to U.S. banks at a rate of 1.00% for the purpose of refinancing the mortgage debt of all U.S. households up to a limit of $50,000 per mortgage on owner-occupied housing units and for mortgages totaling $400,000 at maximum. The maximum allowed refinancing rate under this program for a 30-year fixed-rate mortgage would be 3.0%. Banks could bid the rate down even lower.
I estimate that such a proposal would involve Fed funding in the order of $1.0 trillion. This expansion of the Fed balance sheet, while substantial, would amount to less than what was involved with QE1.
One of the primary aims of the program would be to convert variable rate mortgages into fixed rate mortgages at a guaranteed low rate. This would mitigate a major risk overhanging the U.S. economy at the present time. Variable rate mortgage holders that currently have an interest rate of less than 3% could opt for a package that would lock in 3% at the current scheduled date of repricing.
I estimate that this proposal could lower mortgage payments, on average, by $50 per month for households that currently have fixed rate mortgages. The immediate impact would be lower for current holders of variable rate mortgages. However, removing the uncertainty surrounding repricing should have an important impact on long-term confidence.
The proposal has another advantage: It targets the medicine where the problem is – lower and middle income households. Currently, the only overleveraged sector of the U.S. economy is the household sector and the lower and lower-middle income sectors in particular. The corporate sector has very low levels of leverage in historical terms and the highest cash levels in history. Current government sector leverage is actually quite manageable, with net interest payments on the U.S. public debt equaling only about 1.5% of GDP in nominal terms, and a negligible amount in real terms. The problem with the government sector is future deficits and debts if entitlements are not reformed.
Furthermore, this proposal will allow many families to be able to stay in their owner-occupied housing that otherwise would not be able to. This is particularly true of variable rate mortgage holders subject to repricing. This will tend to alleviate the current oversupply of homes for sale on the market that are driving down prices.
The proposal has another advantage: Assuming that inflation grows by 3% and real wages grow by a modest 2% per annum on average over the next 10 years, the net impact of the proposal is very substantial deleveraging of the household balance sheet over time – in real terms. In fact, within 10 years, the mortgage debt to income ratio (related to this program) would fall by about 50%.
As I made clear here
, in the event of a serious risk of a depression/deflation scenario, Ben Bernanke will favor aggressive measures to avert such an outcome. This proposal targeted at housing fits within the framework of the “deflation took kit” outlined by Bernanke and summarized here
Under this proposal, almost everybody will be happy. Banks will be happy because they get a guaranteed spread for the life of a loan – they have no interest rate risk. The banks will be even happier because the program that lowers default risks on their mortgage portfolios. Consumers will be happy because roughly $50 a month is placed in their pockets to spend. This should help activate the economy and increase employment. Perhaps just as importantly long-term consumer sentiment should improve since consumers will not have the risk of mortgage repricing hanging over them like a cloud. In addition, the proposal has the advantage of targeting economic assistance to the sectors that need it most.
I want to make clear that I am not advocating this proposal from a policy point of view. I am merely suggesting that it is an alternative that the central bank has that is both economically and politically viable.
Is this a free lunch? No. There is no such thing. There will be costs to pay in terms of inflation down the line. At the same time that the net worth of lower and middle income debtors tends to rise in real terms due to a lowered debt burned, the wealth of passive fixed-income creditors and depositors will be reduced. However, when debt levels among the middle and lower-income segments are high, inflation can actually be part of the solution to that problem. Another cost might be a longer-term “moral hazard” cost.
The fact is that when facing depression and deflation, policymakers must choose policies that are least bad. This proposal to tackle the problems in the housing market, and particularly among low and middle-income mortgage holders, might just be one “least bad” alternative. It is certainly better than the “liquidationist” alternative proposed by some which consists of the Fed doing nothing, allowing the economy to collapse, permitting unemployment to rise to 30% and allowing the system to be “therapeutically purged” of its former excesses.
In terms of investment implications, this policy should have a highly beneficial impact on equities (SPY
) by reducing macroeconic risks to growth quite substantially. It should also help bank stocks such as XLF
, Bank of America (BAC
), Citigroup (C
), Wells Fargo (WFC
) and JP Morgan (JPM
). Finally, the policy would tend to place some upward presssure on long-term interest rates (TLT
) as long-term inflationary expectations rise.
Disclosure: I am short TLT.
Additional disclosure: I am short TLT and long TBT and SBND.