patrick.net

Bush will do for the housing market what he did for Iraq....

.....destroy it......

THERE'S NO SUCH THING AS A FREE BAILOUT
by Paul L. Kasriel
Senior Vice President & Director of Economic Research
The Northern Trust Company
August 24, 2007

http://www.financialsense.com/editorials/kasriel/2007/0824.html

PIMCO’s William Gross is now calling for a fiscal policy bailout for the U.S. housing market debacle rather than a monetary policy bailout (see “Where’s Waldo? Where’s W?”). On the surface, Gross’s arguments seem to make sense – on the surface. Gross argues that even a cut in the federal funds rate of several hundred basis points might not lower reset rates on adjustable-rate mortgages enough to prevent the massive looming foreclosures. In addition, Gross argues that such an injection of Fed-created credit could be the catalyst for a run on the dollar, which, in turn, would probably prevent 15-year or 30-year fixed rate mortgage yields from falling enough, if at all, to prevent massive foreclosures. Moreover, Gross argues that a large cut in the federal funds rate would perpetuate Greenspan’s moral hazard policy and would encourage further leveraging in the global financial markets. So as an alternative, Gross recommends that some federal government agency, either an existing one such as the Federal Housing Administration (FHA) or a newly-created alphabet soup, bailout those current home“owners” who otherwise are soon-to-be renters.

I believe that Gross makes some valid points about the implications of a Greenspan-magnitude cut in the fed funds rate. But I do not believe that a fiscal policy bailout of prospective defaulting mortgagees would be “free,” economically speaking.

Let’s assume that the FHA guarantees the refinancing of the approximately $683 billion of subprime and Alt-A mortgages that are scheduled to reset in the six quarters ended 2008:Q4 (dollar amount according to Merrill Lynch). An FHA guarantee is a full-faith-and-credit guarantee of the federal government. So, the market for these new FHA-guaranteed mortgages would overlap with the one for U.S. Treasury securities. That is, FHA-guaranteed mortgages and U.S .Treasury securities are close substitutes. Thus, all else the same, U.S. Treasury security interest rates would rise as investors shift out of Treasuries into FHA-guaranteed mortgages. But because the FHA would be guaranteeing massive amounts of subprime and Alt-A mortgages, market participants would anticipate higher defaults on these mortgages going forward, which, in turn, would cause market participants to expect higher Treasury borrowing requirements going forward to make buyers of these FHA-guaranteed mortgages whole after defaults. So, interest rates on Treasury debt would rise not only because of the substitution effect, but because a greater future supply of Treasury debt would be anticipated. In fact, the interest rates on all other fixed-income securities would rise because FHA-guaranteed mortgages are, to varying degrees, substitutes for other fixed-income instruments.

So, the current federal deficit would rise because of higher interest costs on the public debt. In addition, expected future federal deficits would rise because of higher anticipated defaults on FHA-guaranteed mortgages. Private borrowers would cut back on their borrowing and spending because of the higher interest rates they now have to pay in order to obtain funding. Other private – and perhaps public – spending, then, would be “crowded out” by the increase in FHA guarantees on mortgages. The cost of funds to private equity syndicates would increase, so the dollar volume of “deals” would decline from what it otherwise would have been. This would reduce the amount of shares being bought from households, which, in turn, would reduce an important source of household deficit spending. (For a discussion of the impact on household spending of private equity buyouts and corporations’ stock buybacks, see "Wall Street and Main Street Are Joined at the Hip"). Again, other spending would be crowded out by the increase in FHA guarantees of mortgages.

It is not even clear that the U.S. dollar would not come under downward pressure with a fiscal policy bailout of subprime and Alt-A borrowers. As alluded to above, private spending on research and development and business capital equipment would be crowded out by the government guarantee of less-than-prime mortgages. Slower growth in these types of private spending implies slower future growth in the U.S. economy. Slower future real growth in the economy implies slower growth in our standard of living, especially if we have to devote part of our future production/income to servicing our foreign debt. With the U.S. already a gargantuan net debtor to the rest of the world and with the bulk of our debt denominated in U.S. dollars, foreign creditors might wonder if political pressure would be brought to bear on the Federal Reserve to crank up the currency “printing press” in order to help make principal and interest payments on the debt owed to these creditors. The anticipation of this, of course, would induce investors – both foreign and domestic – to reduce their exposure to U.S. dollar-denominated financial assets, thus causing the dollar to depreciate vs. other currencies.

For the FHA to guarantee the refinanced mortgages of subprime and Alt-A borrowers, a moral hazard policy still would be perpetuated, just not by the Fed. Subprime and Alt-A lenders would be bailed out by the federal government, thus reinforcing the notion that some form of government safety net would likely be there to mitigate the potential losses of investments in risky assets.

So, there is no free bailout to the predicament we have gotten into as a result of Greenspan’s cheap credit and moral hazard policies. For those that think there are free bailouts, I suggest that they read the writings of Frederic Bastiat, a 19th century French political economist, who preached that in economic analysis, one must take into account not only what is seen, but what is not seen. In other words, employ general equilibrium analysis, not just partial equilibrium analysis.

When Bush says that it is not the job of the government to bail out speculators is he talking about people who bought multiple "investment" houses? Or investors who purchased portfolios of speculative subprime debt?

How is it that a repeal of AMT is so difficult but the bailout of FB's are so swift? This bailout is just so upsetting, I like to get my mortgage re-structured too, bastards...

Don't hold your breath waiting for a bailout of FBs or wall street. It is not likely to happen.

The president is not in favor of it. The republicans generally resist market intervention. And even if the democrats (who do like to do this kind of stuff) push a bill through congress, Bush would veot it. So, if you want a market bailout from the US government you will have to wait for a democrat to become president.

However, I do expect the Fed to lower the Fed Funds Target rate before long. It is artificially high (relative to free market rates) and the damage to economic growth will soon be obvious.

But this is par for the course. The Fed always overdoes their interest rate policy. They go to low and then wait to long, and then they have to go too high to make up for it. Then they stay high too long and have to go too low again to make up for that mistake. Over and over again...

Oh please. Bush is not a traditional Republican. Republicans generally disfavor trade protectionism too, but that didn't stop Bush from passing steel tariffs when it suited him.

If his corporate masters tell him to bail out Wall Street, then he will do so. But it will not be called "The Wall Street Bailout Act." It will be called the "American Dream Protection Act" or some such nonsense.

I wouldn't count on a Bush veto.

1989--President Bush unveils S&L bailout plan in February. In August, Financial Institutions Reform Recovery and Enforcement Act (FIRREA). FIRREA abolishes the Federal Home Loan Bank Board and FSLIC, switches S&L regulation to newly created Office of Thrift Supervision. Deposit insurance function shifted to the FDIC. A new entity, the Resolution Trust Corporation is created to resolve the insolvent S&Ls.

http://www.fdic.gov/bank/historical/s&l/

Bush is pretty unlikely to veto. He may be able to affect the debate by threatening to veto, but his threats are largely without credibility anymore and the Congress knows it. Bush's biggest strategic worry is that he vetoes a bill like this (would be), and then gets overridden. He's in bad enough shape already; turn him into a lame duck with 15 months left and no veto power and he might as well quit.

Bush is already caving in anyway. He's just trying to get quid pro quo for his passive-support.

I predict that there will be some kind of garbage legislation passed. It certainly won't amount to a full bailout, though, as that would be prohibitively expensive.

I predict that the legislation will contain three features:

1. There will be extensive provisions designed to "protect" future borrowers with SarbOx type red tape.

2. Current FBs will get a very narrowly drawn bailout. Eg: (1) only for principal residence; (2) only for "nonconforming" loans; (3) You must not have lied on your mortgage application; (4) you qualify for a federal "bailout" loan, which will be given to you before your ARM resets. Undoubtedly, there will be lots of other restrictions, limitations and more red tape.

3. There will be several "pork" provisions designed to bail out favored campaign contributors, lenders located in key congressional districts, etc. The bill will probably also include something about grasshopper research or federal money for a lightbulb museum.

Randy says:
"Bush’s biggest strategic worry is that he vetoes a bill like this (would be), and then gets overridden."

Incredible that 2/3rds of both houses of Congress would support a bailout....

I agree the Fed overshoots their targets. I disagree this is somehow because they're just too dim witted or systematically slow to react. The effectiveness and manner by which the Fed levers work have been changing quite significantly over the past 35-40 years. The way an interest rate cut works in 2007 is very different than how it worked in 1977. The difference between the nominal rate and the real rate has grown tremendously. That is very difficult for the Fed to manage, since they cannot control the real rate directly -- it is just as heavily affected by trade policy and fiscal spending, neither of which the Fed has jurisdiction over.

Anyway, I think the interest rate has been kept artificially *low* for most of the decade, and the monetary effects we're working off now are resultant from the monetary inflation that has produced. Juxtapose the Fed from about 2002-2007 with the ECB for the same time period and it is clear there was a window for the Fed to raise rates more aggressively. Sadly, much of the GDP growth we "gained" by not pursuing higher nominal rate policy is now evaporating because it wasn't fueled by real growth but instead by asset price inflation.

Incredible that 2/3rds of both houses of Congress would support a bailout…

That's why I brought up this subject in the first place. This issue, and associated "proposals" to deal with it are truly non-partisan in nature. This is a good, old fashioned, plan to outright buy votes. And buying votes benefits incumbents regardless of their party. Worse, you don't want to be "the party that tried to throw you and your children out of your house and onto the street", which is exactly what the other side will immediately say once you oppose any "help to the common, innocent, patriotic, hard working, American".

This type of legislation would be among the most likely to override a veto. He won't veto it anyway. Not unless the Dems commit suicide (always possible, they're chronic suicide attempt patients) and do something like attach a troop pullout to the FB Bailout Bill.

"grasshopper research"

"lightbulb museum"

Ahh... Glen, you are making my Friday! I'm with Zephyr on this one. Well that or I "could" hold my bail-out breath and when you call just ask for "Old Blue"?

As per Herb Greenberg, a bailout may salvage a few homeowners but it's not going to support home prices. It will only prolong the agony of the "debt slave" to an overpriced asset. So I just say... whatever.

DinOR :)

goober Says:
Bush will do for the housing market what he did for Iraq…. …..destroy it

"W for Housing Commissioner, '08" :-)

The 'market' in the economic sense of the term has already been destroyed by specuflippers, torched by the REIC and pissed on by banksters. So there isn't much left to destroy over there.

The only thing left standing is a small group of refugee savers who managed to crawl into a (rented) cave - so that is the crowd that will now get carpet-bombed in order to spread 'the american dream'.

SP

80K home owners & prices under 320K. california FB's got to look for somebody else for their share.

Bruce,
No Venice this summer, I haven't been there in three years. Time to go back I suppose! I will look around at travel sites, etc. for more restaurants before I go again though.

Glen,
Thank you for mentioning that Bush isn't a normal Republican! Foreign entanglements, the fiscal restraint of a drunk sailor on shore leave, authoritarian and an eviscerator of the Constitution- he's no Conservative. I am at a loss as to why so many people who consider themselves Patriots (TM), which now apparently means blindly following the president and plopping a magnet on your car, are willing to give up their Constitutional rights for the perception of safety.

Give me a good old fashioned Conservative anyday- fiscal conservatism and stay out of my personal life. Instead we get 'Family Values' "conservatism" which is distort intelligence, recklessly spend money, and hang out in public restrooms all across America looking for the anonymous sex you publicly deplore.

I don't think the Fed is dimwitted. But the data lags make it very hard to confidently change policy without an obvious event. And the impact lags make it nearly impossible to avoid staying in a policy position too long. So by the time they change direction they need a strong action to more quickly counteract the previous overshoot. Then they get painted into a corner by concerns about market psychology, and are loath to fine tune back to a moderate position.

BTW, I think the Fed is having some trouble keeping the target up at 5.25%. It traded at 5.0% weds, and 4.75% for a while yesterday. It has been all over the map on some days in the last two weeks.

I do agree with this decision by The Decider, however.

One thing the president promised not do was a direct bailout of homeowners facing foreclosures or of lenders with financial problems traced to portfolios of defaulting subprime loans.

Such bailouts, he said, "would only aggravate the problem."

It will only prolong the agony of the “debt slave” to an overpriced asset. So I just say… whatever.

Dinor,

I think this is an important observation. Ultimately, some FBs will elect to be debt slaves for at least a few more years. But many more will simply walk away--with or without a bailout.

My hope is that any federal loans given to FBs will be (1) nondischargeable in bankruptcy; (2) subject to typical federal government collection tactics (withholding tax refunds, wage garnishments, etc...) Just like taxes and federally guaranteed student loans.

Let's say you owe $500K on a $400K house. The Feds could offer to refinance your $500K debt at a fixed "affordable" rate. But hopefully they will not do so without extracting their (taxpayers') pound of flesh. Make the FB pay the balance in full or else sic the IRS on them.

But maybe I'm just bitter because I still rent and I'm still paying off my student loans.

Zephyr,
I disagree that the Fed Funds rate has been artificially high. As Randy H states, I think it has been artificially too low for most of the decade, heck, for most of Greenspan's term. The fallout we are seeing today is not a consequence of the recent tightening, but the effects of getting the "Masters of the Universe" on Wall Street, who have been so used to easy credit, used to "more normal" credit conditions.

What does it say about the American economy that we can't stomach a 5.25% Federal Funds rate?

As far as I can tell Bush isn't a normal anything.

SP,

Precisely! What's left to demolish? The "2nd home/vacation home" market? Toast. Condo "specuflipping"? Toast. Other than remote enclaves hunkerd down in the rural areas of the midwest there's nothing left worth bombing!

In naval terms this would be referred to as "making the rubble bounce" (sending in a second missile just for a sh@ts and grins).

Oh and my youngest daughter had a great term for the ultra hip 20 something MEW moms commanding their world from a cell phone and a stroller. "New and Improved Soccer Mom". I kind of like it.

Of course, the big economic news of the day is Bendover Ben's speech in Jackson Hole. As I'm sure many of you have noticed, the markets have reacted favorably to it, which by implication suggests it is being interpreted as a signal for a rate cut. Now, this may be well and true, but I think the comments are being taken out of context. Here is the pertinent section of the speech:

The purpose of the discount window actions was to assure depositories of the ready availability of a backstop source of liquidity. Even if banks find that borrowing from the discount window is not immediately necessary, the knowledge that liquidity is available should help alleviate concerns about funding that might otherwise constrain depositories from extending credit or making markets.

The incoming data indicate that the economy continued to expand at a moderate pace into the summer, despite the sharp correction in the housing sector. However, in light of recent financial developments, economic data bearing on past months or quarters may be less useful than usual for our forecasts of economic activity and inflation. Consequently, we will pay particularly close attention to the timeliest indicators, as well as information gleaned from our business and banking contacts around the country. Inevitably, the uncertainty surrounding the outlook will be greater than normal, presenting a challenge to policymakers to manage the risks to their growth and price stability objectives. The Committee continues to monitor the situation and will act as needed to limit the adverse effects on the broader economy that may arise from the disruptions in financial markets.

The sentence that the markets seem to be creaming over is how, "(t)he Federal Reserve stands ready to take additional actions as needed to provide liquidity and promote the orderly functioning of markets." Seems to me that in the context above, this doesn't necessarily mean a rate cut is a given. Ben seems to imply that the discount window is the preferred tool in this liquidity crisis, but the Fed Funds rate could be used if there are any "early" indications of impact on the broader economy. IE, Wall Street shouldn't expect a "Bernanke Put."

Maybe I'm being hopeful, but that seems reasonable to me. Alternatively, this is just lip service and indeed rate cuts galore are coming...

The Fed Funds rate has been artificially too low for a long time -- until recently. The normal position for the fed funds rate is about 100 bps or more below the 10 year treasury.

The normal position for all rates is to be higher as the duration is longer. Overnight is the shortest duration, and should have the lowest rate. The fact that the fed funds rate is higher than all the other rates on the yield curve makes it clear that it is being artificially pushed to be so high. If the rate were allowed to float freely in the market it would drop by at least 100 bps.

Precisely! What’s left to demolish?

DinOR,

There's still The Fortress!

Zephyr,
I think we discussed this before, but the "normal" calculus of using the 10y treasury as a benchmark comparison for the "normal" fed funds rate seems to me not applicable. The Fed itself has acknowledged "artificially" low long-term treasury yields due to foreign money parked in these securities. Perhaps this underlying cause doesn't matter in the end, but it seems that the Fed has at least taken it into account in determining what they think the rate should be.

The 10 year rate is a market-driven rate. The result of natural forces of supply and demand. The fed funds rate is manipulated by the fed to keep it artificially at the level they have decided upon.

The long bond raes are not artificially low. The current rate levels are the consequence of natural market forces that should be expected to put the rates at their current levels.

If the fed stopped manipulating the market, I would expect the overnight/fed funds rate to fall to 4.0% or lower, and the 10 year treasury would probably settle in around 4.5% to 4.75%.

This would be the natural level with the current economic conditions.

Of course treasury rates are market-driven, but my point (not clearly made) was that compared historically, the current situation is unusual in that "saver nations" have dumped tons of cash into long-term treasuries in a situation not seen previously.

The fed cannot keep the fed funds target at an artificially high (or low) level for very long without causing problems in the economy.

We all saw the bubble effects of an artificially low fed funds rate. We are beginning to see the efeects of an artificially high rate.

Throughout all of this manipulation of the short-term rates, the long rates have been relatively stable.

"There's still The Fortress!"

I stand corrected.

Fire when ready Gridley!

Zephyr,

I see your point. That's why it's so important to get "the cost of money" right. Well said.

The savers of the world look for safe places for their money. This is not new. What is new is WHO these savers are.

Yield inversions are also "natural forces of the market". Zephyr is correct as a static analysis. But as skibum pointed out, the market structure of Treasuries have changed quite significantly over the same period.

If the "natural" Fed target is 100bp below the 10yr Treasury in 1990, then it would need to be more like 250bp below the 10yr in 2007 in order to match the effect of nominal versus real interest rates vis-a-vis inflation. The US has progressively been *losing* nominal rate power as an effect of foreign capital flows.

This is the primary argument against just using a simple, automated or semi-automated, transparent Fed inflation target. Such a target would have to be infinitely complex and is probably impossible to achieve without simply resulting in nominal-rate gaming.

As to the Fed's overshooting, I still disagree. If "Zephyr" is smart enough to see the overshoot, so are the hundreds of brilliant economists, econometricists, and statisticians working for the Fed. They know quite well how long it takes for rate moves to work into the economy, and they know the nature of their own historical data better than any of us armchair policy wonks.

The only folks deluded enough to think they could do the job better are global macro hedge fund managers and autistic fools.

Zephyr,
True re: savers. Moving on, the other thing that's been irking me while following the latest developments is that everyone (talking heads, economists, etc etc) are pushing/expecting the Fed to lower its funds rate to avoid recession, as the "downside risks have increased substantially." Fair enough. Then these folks usually go on to say that a big part of the economy is the consumer. Fair enough. It may not be pretty, but yes, we are a nation of fat, lazy, SUV driving, McMansion-living consumers. Then they all invariably go on to say how the tight credit market and the tight mortgage market leads to lower refi's, less cash-out for consumers to spend.

This is where the argument pisses me off. So, it's now a foregone conclusion that cash-out refi's as a way to keep the economy going is a GOOD thing? Are economists really truly advocating for a return to those times? God help us all!

SFWoman,

I think the problem is that there are no real conservatives left in the republican party, and I'm also not that convinced that there have been for a long time. Real conservative *voters*, sure, but they seem to prefer voting for conservative rhetoric rather than realizing the true nature of the semi-fascist bandits that are really running the party, and turning the other way.

"Anything for a tax cut"

Randy H,
I think that the case-in-point is the fact that the Fed has yet to cut the Fed funds rate as Wall Street Titans have been begging for recently. The Fed sees "downside risks" present, but if they were to overreact, they risk moving when they didn't need to. I see BenB as consciously trying to make moves as slowly as possible. It's like a very slowly responsive, nonlinear and very complex feedback system, but there is only one feedback loop (two if you count the discount rate) that can be manipulated easily. So, you want to manipulate it only when you are fairly certain the effects will be necessary, and perhaps as importantly, predictable.