The Fed

A critique of the ideas in the housing policy white paper the Federal Reserve should not have written

It is not unreasonable to think that three years after the financial crisis fully metastasized, officials in Washington would begin to apply lessons learned from the housing bubble and subprime meltdown. Yet, the Federal Reserve’s latest release of its grand ideas for helping the housing market clearly shows that the lessons of the crisis have failed to penetrate the thick skulls of Washington’s economic bureaucracy.

The newly proposed ideas are from a white paper, authored by a Fed research staff that’s led by Chairman Ben Bernanke. It purports to create a “framework for thinking about directions policymakers might take to help the housing market.” Setting aside the problematic nature of the Federal Reserve casting away its monetary policy duties to wade into this murky ocean of fiscal policy, the framework they create is still frustratingly unhelpful.

The paper highlights three key problems that need to be addressed: the large number of vacant homes that remain unsold, the tightened supply of mortgage credit, and the inefficient foreclosure process. Conspicuously absent from this list is the dominating and never-ending presence of Fannie Mae and Freddie Mac. In fact, on page two of the report, a footnote makes clear that “this paper does not discuss… the future form or role of the GSEs.”

How could a robust paper-this one is nearly 30 pages long, so they were not trying to abbreviate the arguments-that claims to offer a framework for thinking about housing reform intentionally ignore Fannie and Freddie?

One answer to that question may be that the authors are satisfied with the status quo. After all, the Fed’s quantitative easing programs have been most effective at pushing down mortgage rates when buying MBS directly from Fannie and Freddie. Perhaps they desire a healthy supply of agency MBS in future years?

Another answer might be that the report seems to bend over backward to make arguments in favor of having government officials direct the use of capital in the financial system rather than letting the market direct it to the best possible ends. If we learned anything from the financial crisis it is that letting a social goal-like promoting the “ownership society”-provide justification for subsidizing the use of capital for certain sectors of the economy does more harm than good. The subsidies directing capital to housing through the GSEs may have helped some families get into homes faster than ever before, but the housing bubble’s collapse has destroyed most of those perceived gains and more.

Yet, the paper from the Fed is focused on trying to direct capital to achieve particularly desired social ends dressed up as economic ends.

First is the frustration with the large supply of homes on the market today. The Fed rightly points out that the number of homes on the market, and particularly those owned by financial institutions after foreclosure, is at a historic high. This puts downward pressure on housing prices, which the Fed determines to be bad because it exacerbates negative equity problems and the vicious cycle of this leading to more foreclosures and abandoned homes.

The diagnosis of the problem, however, misses the nature of the Fed’s own QE policies that put upward pressure on housing prices as it sought to lower mortgage rates. The housing market has not been permitted to let prices settle at a rate where supply and demand are roughly correlated. An economist’s equilibrium is never perfectly reached in the real world. But this does not disavow the reality that if housing prices were lower, there would be more demand for them, even if the mortgages came with higher rates. (A $300,000 home with a 5 percent fixed rate mortgage would be more expensive than a $250,000 home with a 6.5 percent rate.)

The only way to clear the housing market’s inventory is lower prices-mortgage rates are about as low as they can be at the moment. Instead of recognizing this in the statement of the problem the Fed skips past it to a solution that boils down to turning Uncle Sam into Landlord Sam.

Beyond the complexities of establishing and managing such a program, which the Fed white paper owns up to at least, having the government do so would be a direct intervention into the supply and demand signals that help determine price both for buying a home and renting a home.

If a bank wants to set up a rental program with the homes it owns (assuming it can under federal and local laws), this would be the action of a private player in the market. It’s no different from an individual buying a home and renting it, or a company building a whole neighborhood of homes to rent them. The government doing so, with its ability to subsidize the price and misaligned incentives on determining good lessees, would be stepping into that private market place. Young first-time homebuyers looking for a lower priced home won’t find it because Uncle Sam has skewed the supply signals. Landlords with pre-established rental properties would see increased competition not from another private player but their own government, forcing them to lower rates and generate lower revenue.

Few would stand in opposition to a lower number of unsold homes. But a federal rental program is not the best way to get them off the market.

The unintended consequences of the Fed’s misguided logic continue to pile up under its second set of proposals that aim to increase access to mortgage credit. As if low lending standards had nothing to do with the buildup of the housing bubble and the extension of credit to borrowers unable to pay their mortgage. The Fed authors write, “the extraordinarily tight standards that currently prevail reflect, in part, obstacles that limit or prevent lending to creditworthy borrowers.” They even suggest that banks should be considering products for borrowers that are putting less than 10 percent down on their home, or have FICO scores under 620.

The exact same logic was used during the bubble period, especially the appeal to supposedly creditworthy borrowers that just were misunderstood by lenders.

Once again the staff at the Fed assumes they know best, and what they know is that more money should be invested in mortgages. The favoritism of the housing asset class stems from the socially desired goal of homeownership and housing as an investment, even though there is no reason the government should inherently support either of these goals. And woe be to investors who dare to consider other investments than housing. For the wisdom of Fed economists say credit to mortgage financing is where money should go, no matter what proper due diligence says housing versus other opportunities.

Perhaps more frustrating than continuing to see the Federal Reserve stuck in yesterday’s mindset on housing policy is the paper ignoring the three biggest reasons why more credit is not flowing towards housing: the GSEs underpricing private competition, the legal complexities still enveloping mortgage-backed securities, and the high costs of due diligence on potential mortgage related investments with the current lack of confidence in third-party risk assessment (i.e., rating agency failure). It is not clear that the private sector would provide the exact same level of credit available today in the wake of the GSEs being shut down and legal problems addressed, but thinking about those problems would be a far more proactive process than suggesting lenders simply lower their standards.

Finally, the Fed white paper ambiguously dances around the ideas of principal reductions and mortgage servicing reform in order to avoid more foreclosures. While not taking a hard line on exactly how principal should be reduced, the paper does suggest that it is an idea worth significant consideration-without giving any consideration to the interests of MBS investors who, in the end, happen to largely be American households and pension funds.

Principal reductions would also result in losses to the GSEs, which are bailed out every quarter by the Treasury Department (i.e. the taxpayers). The staff at the Fed suggests in the report that if the gains to the housing market from principal reductions wind up being larger than the losses the GSEs will take, then the taxpayers would be better off on the whole. But maybe the taxpayers should get to determine whether they want to take that gamble.

And that is not even to mention the threat to trust in contracts and rule of law if principle reductions are forced on private companies. Similarly, while problems at mortgage servicing companies continue to persist and misaligned incentives have led some servicers to favor foreclosure over reductions, the answer is not to abandon the justice system that has made America great by choosing winners and losers in the mix.

Are the losses to American household “A” because of a forced principal reduction hitting their pension fund bigger or smaller than losses to American household “B” that is unable to get a modification the mortgage they can’t afford? This is a challenging question, but not one that can be answeredby the Federal Reserve on its own or by any other government official.

The ultimate failure of the Federal Reserve’s housing analysis is that it is too focused on the broken theory of homeownership’s universal values. Rethinking homeownership is critical for getting housing policy reforms right for the future. Homeownership is great for some, but not for others. It can be a good investment, but not for everyone. And while high prices are good for sellers, they are bad for borrowers. Mortgage credit going to housing means financing not going to another asset class. And the government should not influence whether an investor chooses to invest in MBS or a small business or oil futures.

The Fed’s white paper concludes that there is “no single solution for the problems the housing market faces.” This is absolutely true. Unfortunately, the solutions presented in the Fed white paper are not the cure, but rather the continued curse of government control of America’s housing market. The Fed should have no role in housing policy at all, save to end its QE programs that are manipulating the rates on mortgages. Congress and the White House meanwhile should look to take down the roadblocks to private capital imposed by government intervention. Housing prices need to reach their natural bottom. Only then will the housing market begin to recover and homeowners see a positive future.