Page 1 of 3 CREDIT BUBBLE BULLETIN No exit
Commentary and weekly watch by Doug Noland
European Central Bank (ECB) president Jean-Claude Trichet penned an op-ed in
the Financial Times last week: "Europe has Mapped its Monetary Exit." Following
the path of US Federal Reserve chairman Ben Bernanke, Trichet explains in some
detail the ECB's plan for exiting its program of "enhanced credit support." And
further tracing the Fed's footprints, 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."
The president of the New York Fed, William Dudley, stated clearly in an
interview last Monday 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 in London last weekend, British Chancellor of
the Exchequer Alistair Darling commented on Friday 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 about monetary tightening.
In response to Liesman's question on the Fed's commitment to purchase US$1.25
trillion of agency (government-sponsored enterprises', or GSEs')
mortgage-backed securites (MBS), 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" or
equivalent 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 (that is, lending, speculating, leveraging, investing
in risk assets, and so forth).
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 GSEs 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 Mae, Freddie Mac, the Federal Home
Loan Bank, the Federal Housing Administration (FHA), the US Department of
Veterans Affairs (VA), Ginnie Mae and others to accumulate trillions more
dollars in 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 Friday 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 US
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 $70 billion in the past two months
(to $3.22 trillion). And, according to Bloomberg data, year-to-date issuance of
agency (Fannie, Freddie, and Ginnie) MBS is already approaching $1.3 trillion,
compared with full-year 2008's $1.153 trillion, 2007's $1.148 trillion, 2006's
$903 billion, and 2005's $958 billion.
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 $25 billion of agency MBS - on a weekly basis. As
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 about 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 priority 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
stabilize 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. 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. 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.
WEEKLY WATCH
For the week, the S&P500 declined 1.2% (up 12.5% y-t-d), and the Dow fell
1.1% (up 7.6% y-t-d). The Morgan Stanley Cyclicals declined 1.3% (up 49.3%),
while the Transports gained 1.1% (up 6.4%). The Morgan Stanley Consumer index
fell 1.4% (up 11.9%), and the Utilities dropped 1.8% (down 1.9%). The Banks
sank 4.8% (up 2.1%), and the Broker/Dealers dropped 2.4% (up 43.1%). The
S&P 400 Mid-Caps lost 1.5% (up 21.4%), while the small cap Russell 2000
fell 1.6% (up 14.2%). The Nasdaq100 slipped 0.3% (up 35.2%) and the Morgan
Stanley High Tech was unchanged (up 49.4%). The Semiconductors dipped 0.5% (up
46.0%). The InteractiveWeek Internet index declined 0.8% (up 52.1%). The
Biotechs fell 2.4% (up 43.1%). With Bullion surging $39, the HUI gold index
jumped 12.1% (up 35.3%).
One-month Treasury bill rates ended the week at 9 bps, and three-month bills
closed at 13 bps. Two-year government yields dropped 8 bps to 0.84%. Five-year
T-note yields fell 10 bps to 2.29%. Ten-year yields were down one basis point
to 3.44%. Long bond yields were 7 bps higher to 4.27%. Benchmark Fannie MBS
yields fell 5 bps to 4.43%. The spread between 10-year
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