Source:
Govt. vs. the Market: Housing Fundamentals Too Weak, Even for Uncle Sam
Heesun Wee
Yahoo Tech Ticker, Mar 25, 2010 07:59am EDT
http://finance.yahoo.com/tech-ticker/govt.-vs.-the-market-housing-fundamentals-too-weak-even-for-uncle-sam-449382.html
The ECB decided to chip in to the ‘Save Greece’ campaign by extending to year end 2011 their altered eligibility requirements for accepting collateral to repo. Instead of expiring at year end, the ECB will continue to accept BBB- or higher rated collateral instead of having it revert to its previous cutoff of A-. With Greece hanging by its A- rating by a thread, it relieves pressure on those banks that hold Greek sovereign debt. The move is helping European stocks, led by the banks, Greek debt is also rallying and the euro is up. Another over levered situation is getting a reprieve today as Dubai’s government said they will give Dubai World $9.5b to help them restructure. Dubai stocks are up 4%+ in response. UK Gilts are down after a mixed review of the new UK budget release but the pound is rallying after a better than expected retail sales report. With yesterday’s possible tipping point in global bond markets, the US sells 7 yr notes today.
James Surowiecki speaks with Michael Mauboussin, the Chief Investment Strategist at Legg Mason Capital Management and the author of “Think Twice: Harnessing the Power of Counterintuition,” about common investment mistakes, how to improve decision-making, and what investors can learn from the recent stock-market woes. They met last week in New York City.
I have been dismayed about the latest actions out of Washington and Wall Street. The banks are now pushing all manner of mortgage mods and foreclosure abatements. These are little more than “extend & pretend” measures, designed to put off the day of reckoning. They are not only ineffective, they are counter-productive. They reward the reckless and punish the responsible, and create a moral hazard. Worse yet, they penalize middle America for the sake of giant Wall Street banks.
It may sound counter-intuitive, but the best thing for the nation (but not necessarily the banks) is to allow the foreclosure process to proceed unimpeded. We need more, not less foreclosures.
How did we get to this bizarre place in history? A brief recap of our story so far:
It started with the ultra-low rates of 2001-04. It was aided and abetted by an abdication of traditional lending standards, at first by non-bank lenders, but eventually, by nearly all. The Lend-to-Sell-to-Securitizer NonBanks pushed lending standards ever lower to the point of non-existence. This increased the pool of potential mortgage buyers, credit worthiness be damned.
The net result of all this was a credit bubble. I estimate that making mortgage requirements disappear brought between 10 and 20 million marginal new home buyers into the real estate market during the 2,000s decade. This drove prices to unsustainable levels, leading to a huge boom and eventual bust cycle in housing.
Prices have fallen about 30% nationally from the 2005-06 housing peak. As the artificial demand created by free money and an accompanying gold rush mentality disappeared, the housing market collapsed.
Despite this, even down 30% or so, prices still remain elevated by historical metrics. The net result has been 5 million foreclosures and counting. One in four “Home-owers” are underwater — meaning, they owe more on their mortgages than their houses are worth. There are another 3-5 million likely foreclosures coming over the next 5+ years.
The net results of the credit bubble are as follows:
1) An enormous number of families living in homes they cannot afford.
2) Bank balance sheets laden with current bad loans and lots of potential future defaulting loans.
3) Real Estate Sales, despite being propped up with historic low mortgage rates and tax purchase credits, are continuing to slide.
4) A weak overall economy with a very slow, soft recovery.
Whether a function of populist politics or bad economics, the proposals so far appear to address items one and three. But upon closer examination, they do nothing of the kind. In fact, they are actually gaming the system to help issue two — the bad loans the banks are carrying.
Even worse, they are making issue #4 — the economy — increasingly problematic.
We should allow the real estate market to experience a healthy price normalization process. Even though home prices have fallen dramatically, they have yet to reach their historical means relative to income or the cost of renting. This is to say nothing of the usual careening past the median towards under-valuation that typically follows a massive mis-allocation of capital.
We own a home, and have a vacation property. Rooting for falling prices is “talking against my own book.”
Why is it so beneficial to allow foreclosures to proceed unimpeded? Consider the following benefits of foreclosure:
• Increasing Economic Activity: The areas of the country with the greatest foreclosure rates have seen the biggest increase in real estate activity. Look at California and Florida — they have seen enormous upticks in sales versus the lower foreclosure states.
The process moves real estate holdings from weak hands to stronger ones. When someone purchases a home they actually can afford, they end up spending quite a bit of money on additional goods and services. They do renovations, hire contractors, make durable goods purchases, buy cars. They do lawn work, plant gardens, paint and repair. They even hire baby sitters, go out to diner and movies, they spend money in the local community.
The people who are hanging on by their fingernails, however, do almost none of these things. They pay a vastly disproportionate amount of their incomes to service their mortgages. This is not productive economic activity.
• Helping Families: Foreclosures, wrenching thought hey may be, move over-stretched families into housing they can afford. They avoid a steady stream of all manner of excess fees. The banks squeeze whatever they can from delinquent homeowners, who end up futilely tossing $1000s of dollars down the drain.
Worse, the HAMP programs have been totally ineffective in keeping families in their homes. The vast majority ultimately default anyway. More fees paid, more debt accrued, for nothing. The last thing these families need is a banking fee orgy, before they ultimate lose the house anyway.
The HAMP programs have been an enormous taxpayer subsidized boondoggle for the banks, however.
• Punishing the Prudent: The boom and bust saw irresponsible and reckless behavior by lenders and home buyers alike. They overused leverage, disregarded risk, ignored history. Having the taxpayers subsidize this behavior presents a moral hazard.
Worse than that, it punishes the people who behaved prudent and responsibly. Those who refused to buy a home they could not afford, chose not to over-extend themselves, and have been saving for a down payment are the net losers in this.
By working so feverishly to artificially reduce foreclosures and prop up home prices, we punish the first time home buyer, the newlyweds, the savers who want to buy a house they can actually afford.
The net result of all these programs and subsidies for recklessness is that we prevent home prices from normalizing. The people who are punished the most are the group that was not reckless, speculative or foolish.
• Rewarding Bad Banks: Despite the helping families rhetoric, it is not what these mods are about. The various foreclosure abatements, mortgage mods and capital write-downs are little more than a game of kick the can down the road. All of these programs are part of a broad “Extend & Pretend” mind set. They are an extension of the FASB 157 rule changes that allows banks to hide their bad loans.
The entire set of proposals canbe described as “Whats good for the banks is good for America.” Only they are not. The various foreclosure programs are essentially a way the banks don’t have to take their write offs now. Avoid the hangover, have another shot of tequila, push the pain of into the future, regardless of economic cost.
Were the banks required to report their mortgages accurately and/or write them down, they would be revealed as insolvent.
~~~
Now we get to the ugly Truth: The mortgage mods and foreclosure abatement programs are really all about propping up insolvent banking institutions on the taxpayer dollar and at the expense of the middle class. These programs are another losing round of helping Wall Street at the expense of Main Street. It is the worst kind of trickle down economics.
Herbert Spencer wrote, “The ultimate result of shielding men from the effects of folly is to fill the world with fools.” We have done precisely that.
Vice Chairman Donald L. Kohn
At the Cornelson Distinguished Lecture at Davidson College, Davidson, North Carolina
March 24, 2010
The events of the past few years have raised many questions for central bankers. Although prompt and innovative actions by the Federal Reserve and other central banks helped prevent a severe economic downturn from turning into something even worse, our experience also highlighted a number of areas we need to study further to see whether we can improve the conduct of monetary policy. I’ve titled my presentation “Homework Assignments” because I don’t think the answers are clear, though I will venture some tentative thoughts. I have four assignments on my list; I could easily have more. And others would have yet a different list. I recognize that the complexity of these questions could keep us profitably engaged for a whole semester, but let’s see if I can outline some of the challenges and possible responses in an evening.
The first two assignments concern the policy actions the Federal Reserve and other central banks took during the financial crisis. A key part of the Federal Reserve’s response was to fulfill its traditional role of providing backup liquidity to sound institutions during times of financial turmoil. In a break with tradition, we had to provide that liquidity to nonbank financial institutions as well as to banks. One assignment is to evaluate the implications of the changing character of financial markets for the design of the liquidity tools the Federal Reserve has at its disposal when panic-driven runs on banks and other key financial intermediaries and markets threaten financial stability and the economy. In addition to providing liquidity on an unprecedented scale, we reduced our policy interest rate (the target for the rate on overnight loans between banks) effectively to zero, and then we continued to ease financial conditions and cushion the effect of the financial shock on the economy by making large-scale purchases of several types of securities. My second assignment involves improving our understanding of the effects of those purchases and the associated massive increase in bank reserves.
The third and fourth assignments relate to whether changes to the conduct of monetary policy in normal times could make financial instability and its wrenching and costly economic consequences less likely. Number three involves considering whether central banks should use their conventional monetary policy tool–adjusting the level of a short-term interest rate–to try to rein in asset prices that seem to be moving well away from sustainable values, in addition to seeking to achieve the macroeconomic objectives of full employment and price stability. The fourth and final assignment concerns whether central banks should adjust their inflation targets to reduce the odds of getting into a situation again where the policy interest rate reaches zero.1
Changes in Financial Markets and the Federal Reserve’s Liquidity Tools
Financial markets have evolved substantially in recent decades. The task of intermediating between investors and borrowers has shifted over time from banks, which take deposits and make loans, to securities markets, where borrowers and savers meet more directly, albeit with the assistance of investment banks that help borrowers issue securities and then make markets in those securities. An aspect of the shift has been the growth of securitization, in which loans that might have been on the books of banks are converted into securities and sold in markets. Serious deficiencies with these securitizations, the associated derivative instruments, and the structures that evolved to hold securitized debt were at the heart of the financial crisis. Among other things, the structures exposed the banking system to risks that neither participants in financial markets nor regulators fully appreciated.
The implications of these changes are far reaching, but I want to concentrate on those that bear on the tools we use to supply liquidity to the financial system. Every central bank had to adapt its liquidity facilities to some degree, but the Federal Reserve had to adapt more than most. Before the crisis, the Federal Reserve adjusted the liquidity it provided to the financial system through daily operations with a relatively small set of broker-dealers against a very narrow set of collateral–Treasury debt, agency debt, and agency mortgage-backed securities. Those transactions had the effect of changing the quantity of reserve balances that banks hold at Federal Reserve Banks, and that liquidity was distributed by interbank funding markets through the banking system in the United States and around the world. In addition, the Federal Reserve stood ready to lend directly to commercial banks and other depository institutions at the “discount window.” At their discretion, banks could borrow overnight at an above-market rate against a broad range of collateral when they had a need for very short-term funding.
But this structure proved inadequate in the crisis. Interbank markets stopped functioning as effective means to distribute liquidity, increasing the importance of direct lending through the discount window. At the same time, however, banks became extremely reluctant to borrow from the Federal Reserve for fear that the borrowing would become known and thus cast doubt on their liquidity condition. Importantly, the crisis also involved major disruptions of important funding markets for other institutions. Commercial paper markets no longer served as sources of funds to lenders or to nonfinancial businesses; investment banks could not borrow for even a short term on a secured basis when lenders began to have doubts about some of the underlying collateral; banks overseas could not reliably exchange their currency in swap markets to fund their dollar assets beyond the very shortest terms; and investors pulled out from money market mutual funds. These disruptions posed the same threats to the availability of credit to households and businesses as did runs on banks in a more bank-centric financial system. Intermediaries unable to fund themselves were forced to sell assets, driving down prices and exacerbating the crisis; they were unwilling to make markets necessary to allow households and businesses to borrow; and households and businesses unable to borrow were unable to spend, deepening the recession.
Last night, I published this blog’s 13,000th post.
I am apparently in desperate need of a hobby . . .
Busy day (again) Here is what I saved for later in terms of reading material:
• Short Sellers Do Work of Cops on Doughnut Break (Bloomberg)
• As Financial Reformer, Dodd, Again, Dogged by Appearance of Conflict (ABC News) Questions Over Wife’s Role on the Board of Futures Exchange That Could Benefit From Proposed Derivatives Rules
• Chicago Fed National Activity Index is a surprisingly good forecaster of economic activity (Chicago Fed)
• Einhorn vs Allied Capital, Round Two:
-SEC inspector general raises red flags in new report (SEC)
-Redacted Special Investigator’s Report (WAPO)
- Einhorn wants complete, un-redacted report released (Reuters)• New Home Sales at Record Low in February (Calculated Risk)
• Who needs payroll cashing banks? Just go to Wal-Mart (Salon)
• Money DOES buy you happiness… if your friends have less of it (Daily Mail)
• Google to China: Your move (GMSV)
What are you reading ?
I will be speaking later today, along with Josh Rosner of Graham Fisher and Chris Plath of Moody’s (!) at The New York Society of Security Analysts (NYSSA).
The conference is titled The New Governance Environment for Financial Institutions.
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"I sincerely believe, with you, that banking establishments are more dangerous than standing armies; and that the principle of spending money to be paid by posterity, under the name of funding, is but swindling futurity on a large scale." -Thomas Jefferson (letter to John Taylor in 1816)
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