How Deep Is The Hole? The Federal Reserve And Housing

by: John M. Mason

The Federal Reserve is serious. The buying of mortgage-backed securities connected with QE3 has begun in earnest - purchases have already been made; they have just not shown up on the Federal Reserve's H.4.1 statistical release.

Up to now, the Fed's efforts to create QE3 have not shown up on the Fed's balance sheet. I posted on this fact on November 2. As of that date, the balance sheet statistics of the Federal Reserve have shown no impact of the Fed's declared objectives to purchase $40 billion of mortgage-backed securities per month for as long as was needed. The FOMC's decision was reported on September 13, 2012.

The fact that the Federal Reserve has, in fact, been buying was pointed out to me by Christopher Mahony. Massive purchases of mortgage-backed securities are being made, it is just that they don't get reported on the Fed's H.4.1 release until the purchase is settled. And, the purchases have been in the packages of $50 million to $250 million and do not settle for 60 to 90 days.

These data cannot be found in information released by the Board of Governors of the Federal Reserve System in Washington, D. C. They are found on the website of the Federal Reserve Bank of New York. One clicks on "Markets" and then "Open Market Operations" and then "Agency MBS."

If one does this, then one currently comes across this statement:

On September 13, 2012, the Federal Open Market Committee (FOMC) directed the Open Market Trading Desk (the Desk) at the Federal Reserve Bank of New York to begin purchasing additional agency MBS at a pace of $40 billion per month. The FOMC also directed the Desk to maintain its existing policy of reinvesting principal payments from the Federal Reserve's holdings of agency debt and agency MBS in agency MBS. The FOMC noted that these actions should put downward pressure on longer-term interest rates, support mortgage markets, and help to make broader financial conditions more accommodative.

It is also noted that "Settled holdings are reported on H.4.1: Factors Affecting Reserve Balances."

Mahony has calculated that through October 10, 2012, the Fed has acquired $71.5 billion in these agency MBS. The Fed has not released more current information on these acquisitions.

So QE3 is on its way and it looks like it is going to be huge!

Although a lot of the justification for QE3 has been related to the need to get the economy growing faster and to reduce unemployment, one is taken by the size of this third edition of quantitative easing and the fact that it is directed at the mortgage market.

Over the past two years or so, I have frequently questioned the Fed's stated justification for its two earlier attempts at quantitative easing. To me, the thrust of these earlier efforts was not so much to spur on economic growth but to keep the commercial banking system afloat. I argued that by providing so much liquidity to the banking system, the Fed could keep basically insolvent institutions alive while the FDIC closed the most desperate cases in an orderly manner.

I argued that these efforts were blunt attempts, basically throwing spaghetti against the wall to see what would stick. The justification for this approach to monetary policy came from studies of the Great Depression, some of them from the research of Fed Chairman Ben Bernanke. The basic idea is that when the economy is in a cumulative decline, one cannot rely on basic central bank responses. The conclusion drawn from these studies is that in cases of cumulative economic decline the central bank must do everything it can to push money into the banking system, knowing that it cannot count on "normal" economic responses to end the collapse.

Thus, Chairman Bernanke and the Fed threw everything they could into the banking system. It has not been pretty and it has raised lots of questions.

Now we are on to the third effort of quantitative easing. And, this one Mr. Bernanke and the Fed has aimed directly at the housing industry. The size of the intended purchases and the fact that the effort doesn't have an "end" date leads one to reflect on how serious the Fed considers this round to be.

Two pieces of information stand out to me: first, that up to one in four mortgages are underwater; and second, that up to one in five individuals of working age are under-employed.

How far are the mortgages underwater? Ten percent? Fifteen percent? We don't have precise figures on these.

How strapped are American families in terms of their ability to carry debt given that less than 64 percent of the population is participating in the labor force? This number is the lowest in 40 years.

Just given these figures, one can ask a question about how many people in America are still "technically" insolvent? All the government programs aimed at getting banks and people together to rewrite mortgages and debt loads have been disappointing. The size of this problem has apparently not been resolved in the minds of Federal Reserve officials.

And, going further, what about small- and medium-sized businesses? We don't have real good information on these firms but, how many of these organizations are still "technically" insolvent? Business loans and commercial real estate loans on the books of the "smaller" banks are still declining even though they maybe picking up at the largest banks.

What if many of these "technically" insolvent households and business actually fold? What, then, will be the condition of the financial system? One could argue that many financial institutions that hold residential mortgages or commercial real estate loans, or, securities related to these instruments, are also "technically" insolvent.

Is this what the Federal Reserve is really worried about? Is this why the Federal Reserve has entered into a massive, seemingly endless effort to provide funds for holders of mortgages or securities backed by mortgages?

Is the Fed trying to create a "bubble" in the housing market so as to get home values above mortgage amounts? Is "Helicopter Ben" trying for a sector inflation to protect the financial system?

The old adage is "Never fight the Fed." If the Fed is attempting to inflate housing values, maybe an investor should bet "with" the Fed and go for investments in housing.

Warren Buffett seems to be doing this.

The legendary investor has been buying up real-estate brokerages around the country as he bets on a housing turnaround. Now, he is partnering with Brookfield Asset Management, a Canadian real-estate investor, to more than double the size of his brokerage business. (Yahoo! finance.)

How deep is the hole in housing finance? It seems as if the Federal Reserve thinks it is pretty deep!

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.