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Fed's Tricks, Obama's Mortgages

Prof. Peter Morici - 10/24/2011

I. Obama Mortgage Program Sows another Credit Crisis


President Obama is revamping, yet again, his program to help middle and working class homeowners, who already owe than their homes are worth or have less than perfect credit ratings, refinance their mortgages. This is all about getting past 2012—not jump starting the economy—and could create yet another credit crisis for Mr. Obama or future president to address.

Since early 2009, through QE1, QE2 and now Operation Twist, the Federal Reserve has suppressed mortgage rates—to jump start housing sales and raise prices, and to assist homeowners with good credit and some equity left in their homes to refinance. All this was intended to increase purchasing power and help lift the economy. And to some limited extent, it has worked. It stopped the slide in housing values, though it has not raised them much, and it has freed up some purchasing power. However, smart homeowners did use much of the money saved on monthly payments to pay down other debt—auto loans, credit cards and the like.

In parallel, the President initiated programs through Fannie Mae and Freddie Mac to help homeowners refinance, up to 125 percent of their home’s value. Those permit homeowners to refinance even if they owe up to 25 percent more than their homes are worth, and up to a point those make some sense.

Now the President proposes to open the floodgate—like a political candidate promising the moon, but this time delivering the cream cheese before the election and in a wholly irresponsible fashion.

He proposes to let homeowners, still up-to-date on their mortgages, refinance no matter how much the value of their home has fallen below what they owe and without cumbersome underwriters checks—home appraisals, and rigorous credit and income checks. That is a prescription for more failed loans and another crisis in mortgage finance down the road or huge losses for U.S. taxpayers that can only be accommodated by even bigger deficits and printing money.

For example, homes underwater by 50 percent today will sooner or later be sold and then what? Fannie Mae and Freddie Mac get stuck with the loss. Either future homebuyers seeking loans will have to pay outsized fees to cover these fees, or the taxpayers bail out these government sponsored institutions yet again. Either way, the housing market will take a big future hit, for campaign largess granted today.

Virtually all those homeowners that could not pay their mortgages in 2007, 2008 and 2009, were able to make payments on the day they took out their loans, but when borrowers with big credit card balances even lost some overtime work, never mind their jobs, they could not make payments and started down the road to foreclosure. Consequently, more rigorous underwriting checks have been put in place to fix that.

Now the president proposed to throw those out the window, and let folks who may earn $80,000 a year and owe $200,000 on their home qualify for lower interest mortgages without checking if they have been using the ATM machine to pay their mortgages or otherwise running up credit card debt and auto loans. No checks will be required to ensure applicants have not had a recent dip in income owing to a layoff—and we still have lots of those if the Administration had not noticed.

The impact on consumer spending from this additional credit won’t be large enough to be worth the risk—this new program would perhaps, though not likely, refinance as many mortgages as previous efforts and those did not lift the economy much. Banks, fearful of being villainized as accomplices or even ultimately blamed for initially writing the mortgages, may prove smartly reluctant to participate.

What the president is about to do won’t create another housing bubble—too many foreclosures are about to hit the market—but it is politically inspired and an economically irresponsible act that could easily result in many more foreclosures and another credit collapse down the road.

II. The Fed Is Out of Tricks to Jump Start Housing and Economy

Federal Reserve officials are flailing about for new tools—for example, more quantitative easing or a better communications strategy—to jump start the economy. Sadly, the Fed has few arrows left in its quill, most are crooked, and Mr. Bernanke appears to not know where the target is.

The legend on Wall Street is the economy remains dormant because depressed housing values prevent homeowners from refinancing their mortgages to free up disposable income and boost consumer spending.

From November 2008 to this past June, the Fed suppressed mortgage rates and helped put a floor under housing prices by purchasing mortgage backed securities and long-term Treasuries. More recently, under Operation Twist, it has sold short-term Treasuries to purchase long-term Treasuries—a maneuver aimed at accomplishing similarly low mortgage rates.

Still, sales of existing and new homes sales remain depressed, and most of the modest increase in residential construction is in multiunit housing. Young Americans are more frequently renting rather than taking the plunge into home ownership, and many older Americans can’t sell their homes for what they paid.

During the boom years, thanks to “creative mortgages” that encouraged individuals to speculate in real estate, more homes were built than were needed, and the resulting oversupply will take years to work off.

The pace of foreclosures and number of homes banks place on the market will pick up through 2012, because banks are working through the legal morass created by robo foreclosures. Though banks face civil penalties or an expensive settlement with the States’ Attorneys General, most homeowners not able to make payments will have to move out and their homes will hit the market. This extra supply, realtors’ hype notwithstanding, will keep housing values depressed for at least the next two years.

A second recession could drive down values, already off about 31percent since their July 2006 peak, another 10 to 20 percent.

Considering the risks, renting and postponing homeownership makes sense for young people not blessed with Wall Street or high tech jobs, and not working in cities like New York and Washington where the housing recession has passed in upscale neighborhoods.

For most young people, it would only be rational to invest in a home if they could obtain a mortgage at zero or negative interest rates.

Currently, the rate on five-year adjustable rate mortgages is about 3.2 percent. If the Fed could get the investors who buy Fannie and Freddie bonds to accept interest rates of minus 3 percent, then young folks could be offered mortgages with appropriately negative interest rates. To accomplish that feat, the Fed would have to buy all those bonds itself—that’s right the Fed would finance all federally guaranteed mortgages and write off 3 percent a year. I can just hear Ron Paul now.

For these reasons, with or without cheerleading from the Fed, a housing recovery is not going to lead economy out of its current funk.

The U.S. economy does suffer from too little demand, and another popular myth is that this is also caused by households saving too much. Although the personal savings rate did jump from 2.4 percent in 2007 to 6.2 percent, just before the recovery began in mid 2009, it is now down to 4.5 percent.

The net impact on aggregate demand of the 2.1 percentage point increase in the savings rate is about $275 billion—this pales by comparison to the $550 billion drain on demand imposed by the trade deficit.

Moreover, Americans can only get along without saving a reasonable amount if they expect their government to borrow, forever, large amounts from foreign sources to finance their retirements. Greece has demonstrated how well that model works.

Nope. To jump start the economy, the trade deficit—which is almost entirely the deficits with China and on oil—must be addressed. That requires confronting China’s undervalued currency and mercantilism, and finally developing America’s abundant oil and gas resources.

Mr. Bernanke is not permitted to communicate those facts, because those issues are the purview of the Treasury and Energy Secretaries. But don’t look for help from those gentlemen, because their boss “knows” taxing millionaires is the answer.