The American Enterprise Institute (AEI) on Oct. 17 hosted the latest in its six-year series of conferences on the state of the housing bubble that collapsed in 2007 and contributed to the 2008 episode of the ongoing global financial crisis.
After a brief introduction by the moderator, AEI's Alex Pollock, accompanied by some useful slides, each presenter spoke in turn.
Jay Brinkmann, chief economist at the Mortgage Bankers Association; Mark Fogarty, editorial director of National Mortgage News; Desmond Lachman of AEI; Chris Whalen, executive vice president and managing director of Carrington Holding Co.; and John Makin of AEI discussed the relationship between the bubble and the Federal Reserve's loose monetary policy.
Brinkmann noted the growth of the Fed's balance sheet and the fact that it did not hold mortgage-backed securities (MBSs) at all until 2009. He offered an intriguing perspective by pointing out that for the Fed to acquire more than $170 billion in MBSs, it would have acquired these from private-sector investors.
This is a twist on the conventional argument that the Fed is buying these securities to fill in a gap in demand due to the recession. He asked at what point the Fed's activity crowds out the private investors.
Then he asked what effect an exit might have on interest rates. Significantly, Brinkmann raised the prospect that as an alternative to withdrawing liquidity from the housing market, it might buy $500 billion to $600 billion in repurchase agreements, but this choice would roil markets in an unknown way.
Fogarty drew an analogy between the Fed's market interventions and the Dr. Dolittle character "pushmi-pullyu." He lamented the fact that even talk of tapering in June caused interest rates to rise, and thousands of people in the mortgage business lost their jobs. He quipped that he tracks the size of the industry by the equivalent U.S. city it would represent, and it has gone from Albuquerque, N.M., to East Lansing, Mich.
Lachman gave an update of a presentation he usually makes at conferences on the European debt crisis. He has questioned whether the euro can survive and whether the European Union has the necessary institutions in place, such as a common bank regulatory system, to support the euro.
He has consistently criticized the European Union, led by the Germans, for pursuing an austerity program that puts enormous stress on the peripheral countries of Spain, Portugal, Italy and Greece. He warned that a pending case in the German constitutional court could put limits on the ability of the European Central Bank to maintain a supportive monetary policy. In his view, the chance that Europe could slip back into a recession poses the greatest risk to global economic growth.
Whalen's theme was that while the Fed is supporting the mortgage market by buying securities, the financial regulators are offsetting this effect by imposing tougher regulations that create uncertainty as to the ability to sell mortgages into the secondary market. The newest version of Basel capital rules is making banks reluctant to make any loans that aren't guaranteed, and with the difficulty in securitizing mortgages, banks are bidding to hold jumbo mortgages in portfolio.
As Brinkmann did before him, Whalen expressed an unconventional view of Fed policy. After reporting that Fed officials he has spoken with have no credible explanation from a monetary policy point of view as to why they are buying MBSs, except that it supports housing, he questioned the wisdom of a policy that, in effect, taxes the least creditworthy borrowers ½ percent to ¾ percent in the form of higher mortgage rates, while the government is able to borrow for nothing.
Finally, Makin returned the discussion to the bubble theme and suggested that as the Fed oscillates between buying Treasurys and supporting the housing and equity markets, the results are showing up in the form of real estate bubbles in New York, Toronto and other urban centers where foreign investors have plenty of cash to spend.
Makin then took up the other headline issue, what the Fed's continued accommodation means for the role of the Fed and what challenges it poses for Janet Yellen, the likely incoming Fed chairman. He found that financial markets have developed "an uncomfortable codependence" with the Fed, because investors are convinced that there's a "Fed put," so they don't have to worry about issues that would otherwise stress the markets. Meanwhile, the tepid recovery is stretching toward the outer bounds of typical expansions, now in the 54th month, where the average is 58.
The advice for Yellen comes in two parts. First, give a big speech to let the markets know that the Fed can't do everything, in order to lower expectations that the Fed will maintain ease until unemployment drops to 6.5 percent, because, in Makin's words, "There's no empirical support for this relationship (between interest rates and unemployment)." The other thing Yellen must do is to keep an eye on asset prices for signs of bubbles and make sure the Fed's reactions to problems don't inflate the bubble further.
I have predicted ever since the onset of the Fed's quantitative easing policy that the Fed will not be able to withdraw this performance-enhancing drug, which it administered in order to stimulate the economy leading up to the 2012 election.
Instead, the financial markets may bring the policy to a halt, either by acting first or by reacting more strongly than the Fed expects to any sign of tapering. The mini-spike in rates that occurred in June as a result of mere talk of a taper is just a sign of what could happen.
Ironically, if the economy continues to languish, and especially if it relapses into a recession, there's a fair chance the Fed will move even further to expand its intervention, first by buying repos, as Brinkmann suggested, and ultimately by buying corporate bonds and equities, all under the rubric of "expanding the range of assets in the portfolio."
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