No Exit:
ECB President Jean-Claude Trichet penned an op-ed in today’s Financial Times, “Europe has Mapped its Monetary Exit.” Following the path of Chairman Bernanke, Mr. Trichet explains in some detail the ECB’s plan for exiting its program of “enhanced Credit support.” And further tracing the Fed’s footprints, Mr. Trichet is keen not to spook the markets: “Stressing the importance of the exit strategy should not be confused with its activation: it is premature to declare the financial crisis over. Today is not the time to exit.”
President of the New York Fed, William Dudley, stated clearly in Monday’s interview with CNBC’s Steve Liesman that he believes it is too early for the Fed to begin its monetary stimulus exit. “…The economy isn’t growing very fast and we do have a very high unemployment rate.” Deep structural impairment ensures that there will be no agreeable time for policymakers to reverse course.
Ahead of the Group of 20 meeting, UK Chancellor of the Exchequer Alistair Darling commented today that nations should “abandon measures” when recovery takes hold. If it were only that easy. The Fed has already promised markets an extended period of ultra-loose monetary conditions. And I would expect dollar vulnerability (strong euro) coupled with more general systemic fragilities will keep ECB “exit” policy stalled or, at best, restricted to tiny Greenspan-style baby steps.
I’m rather skeptical with respect to central banker “exit” chatter. As markets have recovered and economies stabilized, they have been compelled to articulate somewhat coherent plans for returning to a more stable monetary backdrop. On the one hand, central bankers are keen to reassure the markets that inflation fighting remains a top priority. At the same time, central banks go to great pains to ensure the markets that no meaningful monetary tightening is in the offing anytime soon. On the surface this appears an act of walking a fine line. In reality, markets these days fret only monetary tightening.
In response to Mr. Liesman’s question on the Fed’s commitment to purchase $1.25 TN of agency MBS, Mr. Dudley made telling comments. “Market expectations are very, very important. And the market expects us to complete these programs, to do the full amount. So to contradict that market expectation, I think, is a pretty high hurdle.”
When I contemplate “exit” strategies, I think specifically in terms of policymakers eliminating government market intrusions that distort the price and flow of finance throughout the financial system and real economy. Today – and over the years – one can certainly look to the (activist) Federal Reserve’s (and other central banks’) manipulations of the targeted “Fed funds” rate as a fundamental government intrusion. For years now, artificially low “pegged” borrowing costs have distorted pricing and price relationships for financial instruments and risk more generally. Over time the Fed became only more comfortable – and encroaching – with its capacity to influence market behavior (i.e. lending, speculating, leveraging, investing in risk assets, etc).
Yet, as I’ve argued over the years, the government’s intrusion into our nation’s mortgage market has likely been as consequential in distorting both market pricing and the allocation of financial and real resources as loose monetary policy. The GSE’s used the market’s perception of implicit government backing to balloon their books of business to $5 Trillion. Today, more explicit Washington guarantees will empower Fannie, Freddie, the FHLB, the FHA, VA, Ginnie Mae and others to accumulate Trillions more risk exposure. I can’t take any talk of an exit strategy seriously until I see some coherent plan for disengaging the federal government from our nation’s mortgage industry.
>From this morning’s Wall Street Journal (Nick Timiraos and Deborah Solomon):
“In the past two years, the number of loans insured by the FHA has soared and its market share reached 23% in the second quarter, up from 2.7% in 2006… FHA-backed loans outstanding totaled $429 billion in fiscal 2008, a number projected to hit $627 billion this year… Before the boom, the FHA wasn’t a big player in the housing business because it didn’t follow private lenders in loosening its standards. Borrowers had to fully document incomes and insured loans were capped at $362,000. Congress increased those limits last year to as high as $729,750 in the most expensive markets. In August, the FHA and the U.S. Department of Veterans Affairs backed 40% of loans for all home sales.”
It is as well worth noting that Fannie Mae increased its book of business (retained mortgages and MBS guaranteed) by $70bn in the past two months (to $3.22 TN). And, according to Bloomberg data, y-t-d issuance of agency (Fannie, Freddie, and Ginnie) MBS is already approaching $1.3 TN, compared to full year 2008’s $1.153 TN, 2007’s $1.148 TN, 2006’s $903bn, and 2005’s $958bn.
So, it has reached the point where Washington is underwriting the majority of existing mortgage debt throughout the system and is now backing essentially the entire amount of net new mortgage Credit. Meanwhile, the Federal Reserve is purchasing/monetizing about $25bn of agency MBS – on a weekly basis. As Mr. Dudley stated, “Part of the whole point of the agency mortgage-backed securities purchase program was to drive mortgage rates down to therefore make housing more affordable – to cushion the decline in the housing market. So I think it has been very effective.”
Effective perhaps, but what about an exit strategy? Well, I see a “No Exit” sign. These distortions have been going on for too many years and become too systemic. Indeed, government interventions are at the core of systemic fragilities that ensure Washington will continue to meddle. Exiting government intervention would entail the Fed normalizing rates and ending its massive program of monetization, while an exit by the federal government would entail an end to its expansive program of guaranteeing Trillions of mortgages and mortgage-backed securities. Understandably, the markets spend little time fretting the possibility of Washington getting cold feet on mortgages (or rates).
The Mortgage Bankers Association was out this week with a proposal for revamping the GSEs. From The Wall Street Journal (Nick Timiraos): “A mortgage-industry trade group is calling for Congress to transform Fannie Mae and Freddie Mac into several smaller privately held companies that would issue mortgage securities carrying an explicit government guarantee.” With the help of a government-directed “bad bank,” Fannie and Freddie could be restructured and, apparently, have another go at it. The federal government’s explicit backing of MBS was the key facet to the proposal, a feature seen as necessary for the market’s acceptance of the mortgage securities.
The Administration is to issue its own recommendations for mortgage overhaul next year. We can only hope that this scheme of breaking the GSEs into a group of new “private” companies – benefitting from explicit government debt guarantees – is not adopted. The last thing the system needs going forward is a bunch of little Fannies running around – with hot stocks – trumpeting a seductive story of a new and improved risk models that can promote mortgage lending, housing recovery, and economic growth – with the taxpayer on the hook for only more losses.
As I have written previously, the number one policy priorty these days should be to ensure the course of policymaking does not bankrupt the country. The Federal Reserve must do its part first and foremost by protecting our currency. The Fed must in a timely manner exit its crisis management regime of zero interest-rates and massive monetization – especially of MBS. To avoid “bankruptcy,” the federal government must move aggressively to exit massive deficit spending and the accumulation of systemic mortgage risk.
Regrettably, signs read No Exit on all fronts. And it is this mortgage issue that worries me the most, as few seem to appreciate the mounting risks. Conventional thinking has it that the governent can step in temporarily and stabilze the housing markets. And when home prices reflate and the economy recovers, the private Credit system will take over as the federal government gracefully exits.
The more likely scenario is that federal government market intervention further distorts the marketplace – creating a dyamic whereby only government-guaranteed mortgages attract market demand. Any move by the government to retreat from its backing of the mortgage market would risk acute instability. And, at some point, the government’s accumulation of debt and mortgage obligations would begin to impact the market’s view of creditworthiness.
There is the appearance that government intervention throughout the mortgage marketplace provides a free lunch: Households, once again, enjoy access to plentiful cheap mortgage Credit, while there’s no impact to the cost of federal borrowings. Why would anyone in their right mind even contemplate an Exit – especially when things remain so fragile? Why not wait a year or two or a few…
Yet I would argue that there is a huge and festering (latent) cost to Washington’s mortgage operations. At some point along the way – and you can count on it being a rather inconvenient juncture for the markets and economy – creditworthiness will become a hot issue. The market will finally demand higher yields for Treasuries, agencies, and GSE MBS – and will surely be less than enamored with our currency. MBS backed by today’s artifically low mortgages will come back to bite. And when the market turns against “federal” debt obligations, you can count on the market really, really turning sour on mortgage risk. That will mark the point when years of government market interventions and distortions come home to roost.
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