Wikinvest Wire

Monetizing the housing debt

Thursday, November 12, 2009

In reading the newspapers over the last eight months, since the Federal Reserve decided to print money on a massive scale in order to buy $300 billion in U.S. Treasuries along with about a trillion and a half dollars in mortgage related debt, these two groups of purchases have been viewed quite differently.

The former is seen as a particularly bad thing for a central bank to be doing as this money created "out of thin air" is used to directly fund government spending, spurring comparisons to Zimbabwe and Weimar Germany where similar efforts led to hyper-inflation.

However, the latter is viewed as something of a benign undertaking (by comparison, at least), widely perceived as providing needed support for housing in the U.S. by creating a market for housing debt that might not otherwise exist.

After all, would you buy 2003-2008 vintage mortgages that have been "securitized" by Wall Street firms or one of the two wards of the state - Fannie Mae and Freddie Mac - if the Fed wasn't buying the stuff too?

I wouldn't.

Is there really that big of a difference between these two?

Since the U.S. government and their "too big to fail" banking friends now essentially own the entire domestic mortgage market (causing understandable confusion as to which way the arrow would be pointing on a hypothetical org chart that included the U.S. government and "quasi-government" organizations like Citibank and Bank of America) is there really that much of a distinction between U.S. debt and U.S. housing debt?

By buying all this stuff, isn't the central bank effectively monetizing the housing debt?

And shouldn't a lot more people (particularly in China and Japan) be concerned?

As shown below in the now familiar depiction of the Federal Reserve's balance sheet, since the financial crisis has ebbed and banks are able to pay back some of the money they had to borrow when it looked like the entire world was going to implode, the only items that continue to grow are U.S. Treasuries, mortgage-backed securities (MBSes), and agency debt in the form of loans to Fannie and Freddie.
IMAGE Clearly, there are big differences between U.S. debt and these two forms of housing debt.

For example, when the government sells Treasuries to the central bank in exchange for newly printed money, it does so with the tacit understanding that the money will never have to be paid back.

But, when the Fed does the same thing in exchange for Fannie and Freddie bonds, then...

Well, actually, these two appear to be one and the same. The GSEs are fundamentally bankrupt, a characterization that, save for its ability to borrow and print money, applies to the U.S. government as well, and there would seem to be little chance of all the GSE bonds owned by the Fed being redeemed at full value unless the government steps in with borrowed money or, in the oddest of all circuitous monetary routes, with money it received from the central bank itself.

However, there is a distinction between U.S. debt and mortgage backed securities. In the case of the latter, newly created money is paid to whoever used to own the securitized loan - Fannie, Freddie, Citibank, Bank of America, etc. - and then, in theory at least, the central bank sees returns based on homeowners making their mortgage payments.

The only thing is, more and more homeowners are no longer able to make their payments and, as a result, the value of these securities would have tumbled to unknown depths if not for the central bank coming to the rescue and paying what others won't.

What is the true value of these mortgage backed securities?

In theory, we'll find out early next year when the Fed stops buying them, but, like the homebuyer tax credit, don't be surprised if this wildly popular program is extended, perhaps indefinitely as waves of foreclosures come ashore in 2010 and 2011.

Perhaps it would help to consider the similarities between the Fed using its printing press to buy Treasuries and to buy MBSes.

On the one hand, you have a government that got itself into a jam by spending more money than it could bring in or borrow at low interest rates, so the central bank had to print up money to make up the difference, trading newly created U.S. dollars for U.S. Treasuries.

On the other hand, you have a housing market that got itself into a jam, enabled by the 30-year government drive for higher rates of homeownership which was financed by the government sponsored owned mortgage giants and banks now deemed too big to fail, all of this culminating in one more in a long series of bursting asset bubbles that appears to be business as usual in recent decades for the U.S. economy.

That the Federal Reserve has to print money "out of thin air" to buy $1 trillion or so of this souring mortgage debt shouldn't come as too big of a surprise.

In both cases it's a matter of throwing good money after bad, the odds of the Federal Reserve getting anywhere near what it paid for these MBSes (if and when it ever goes to sell them) being about as good as the odds of the U.S. government running a sufficient surplus to pay back any of the $300 billion that was given to it by the central bank.

The system wasn't set up to work this way.

If the founding fathers knew that we had created yet another central bank and, not only was it printing up money to fund government spending but it was buying up home loans, they'd roll over in their graves (except maybe for Alexander Hamilton).

Since its founding almost a hundred years ago, the central bank has, for the most part, done its job simply by buying and selling treasuries, a fact that is clear to see in recent data below.
IMAGE But, over the last year or so, there's been a radical change in what the central bank buys with money it creates with a simple keystroke and, now that housing and government activities have been so intertwined, is there any real difference between the U.S. government's finances and the finances of the nation's housing market.

It's one thing to step in and provide support for commercial paper markets and money markets, but it's quite another to step in and support the housing market that is now almost wholly owned by the U.S. government in one way or another.

You don't just "unwind" this kind of support.

Of course, if home prices zoom back to their 2005-2006 highs, it's quite possible that the GSEs will spring back to life despite being in the hole by over $100 billion with the red ink still flowing freely. In this case, the Fed could probably sell all its MBSes back into the market and all would be square.

But, that seems about as likely as the U.S. government running a surplus.

If the mortgage backed securities do get sold back into the market in the coming years at anywhere near the price the Fed paid, then all we'll have succeeded in doing is re-inflating the housing bubble, which, come to think of it, is probably the current plan.

But, more likely than not, all this new money that has and will continue to be conjured into existence to buy bad assets - be they U.S. treasuries, bonds issued by Fannie and Freddie, or home loans made against overpriced houses - will all just make the rest of the U.S. money currently in existence less valuable simply because there is more of it.

Maybe a lot less valuable.

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Anonymous said...

Printing is hidden tax on consumers. All consumers are being taxed by the central bank, and the resources loaned back to them. This is a recipe for a lower standard of living, and debt slavery.

Workers cab buy less per hour worked, and retirees can buy less period. Thomas Jefferson was right, "If the American people ever allow private banks to control the issue of currency, first by inflation, then by deflation, the banks and corporations that will grow up around them will deprive the people of all property until their children will wake up homeless on the continent their fathers conquered."

Anonymous said...

Glenn Beck makes more sense every day, in a childish kind of way.

Anonymous said...

Excellent analysis. But, one major error of anachronism. Founding fathers (1776) had no clue about central banking, a very 20th century invention. "Monitory Policy" in 18th century was very distributed and was primarily based on "money = genuine representation of value" equation, mostly through species metals or commodities. Since there was no fiat money, not much need for a central bank.

Anonymous said...

Founding Fathers and central banking policy? Like Founding Fathers and aviation policy or policy on nuclear deterrence?

Tim said...

Wikipedia says:

1781–1836: The Bank of North America; the First, and Second, Bank of the United States

Some Founding Fathers were strongly opposed to the formation of a central banking system; the fact that England tried to place the colonies under the monetary control of the Bank of England was seen by many as the 'last straw' of English oppression and that it led directly to the American Revolutionary War.

Lord said...

It is entirely a matter of what price they are buying them at. Fortunately for them, they can always ensure it is a good price.

Anonymous said...

Founding fathers on money creation

I believe that banking institutions are more dangerous to our liberties than standing armies. If the American people ever allow private banks to control the issue of their currency, first by inflation, then by deflation, the banks and corporations that will grow up around [the banks] will deprive the people of all property until their children wake-up homeless on the continent their fathers conquered. The issuing power should be taken from the banks and restored to the people, to whom it properly belongs.
Thomas Jefferson

"History records that the money changers have used every form of abuse, intrigue, deceit, and violent means possible to maintain their control over governments by controlling the money and its issuance."
James Madison

They Founding Fathers after the fiasco with the paper money Continental authorized by the Articles of Confederation, STRIPPED the power to create paper money from the Constitution that created the current Federal Government. The power to emit "Bills of Credit" aka paper money, was included in the Articles of Confederation, was included in early drafts of the US Constitution, but was stripped from that Constitution during the Constitutional Convention by a vote of 9 t0 2.

see below for portions of the debate and the vote

"Mr. Govr. Morris moved to strike out 'and emit bills on the credit of the United States' If the United States had credit such bills would be unnecessary: if they had not, unjust & useless."

Mr. Read, thought the words, if not struck out, would be as alarming as the mark of the Beast in Revelations"

"Mr. Langdon had rather reject the whole plan than retain the three words '(and emit bills)'"

"On the motion for striking out N. H. ay. Mas. ay. Ct. ay. N. J. no. Pa. ay. Del. ay. Md. no. Va. ay.* N. C. ay. S. C. ay. Geo. ay."

Anonymous said...

I have looked for information about the prices at which the Federal Reserve is buying mortgage-backed securities, and have found none so far. Your article seems to take the position that the Federal Reserve is buying at par value, rather than at discount value, and this is the tone of all other articles on the subject that I have seen so far.

What reason is there to assume that the Federal Reserve is not buying at a discount?

Choosing from whom to buy, and at what percentage of par value, is potentially a powerful tool for reimbursing "good" holders of securities, while ignoring "bad" holders of securities.

Is there any source for hard information on this topic?

Tim said...

Not that I know of.

Clarissa Alverson said...

Yes, I agree that it's basically the same as monetization in the sense that the Fed is creating money to buy assets. But, as was the case with their recent T-bond purchases, these Fed purchases are effectively sterilized if the money is not distributed through the wider economy. The Fed's goal is to purchase just enough MBS to recapitalize the undercapitalized banks, in other words, it only wants to replace the amount of money that's being destroyed by loan defaults. In theory, this should not be inflationary because it merely supports the prices that rose during the last round of easy money and prevents deflation. However, in reality, it's not so simple. Some banks have balance sheets so deeply impaired that they won't be able to resume normal lending anytime soon, while others have already paid back their TARP and have their magic bubble wands already in hand. The one bubble that the Fed desperately wants to reflate is housing, because that would enable underwater homeowners to sell their homes, and keep the loan payments flowing. But it's more likely the bubbles will show up in other areas. The Fed will probability tolerate bubbles in equities, gold, and bonds, but if those bubbles start creeping into commodities like food and energy, look out. That's why they've got the CFTC working overtime right now! This puts the Fed between a rock and hard place because if the commodities' bubble shoots through to the CPI, it will be pressured to withdraw monetary easing even though there are still some very big insolvent banks out there.

Our biggest fear is that the Fed MBS purchases are creating an artificial support for the bond market, as did the earlier Treasury purchases. I have read that the Fed is basically just exchanging T-bonds for MBS, since the same institutions that are selling the MBS to the Fed can hold T-bonds to meet their reserve requirements. If that's the case, the government will just keep rolling out wave after wave of deficit spending on the artificially low interest rates. Everybody keeps commenting on the size of these record-breaking weekly Treasury auctions and saying the market really shouldn't be able to absorb this kind of volume, and they are absolutely right! This Fed support effectively prevents the bond vigilantes from firing their shots across the bow like they did with Clinton in his first term. So, the big danger I see is that the public debt gets too far out on a limb (it may be there already), and then the Fed ends the MBS purchase support, causing rates to spike abruptly and the bond market to go into free fall.

Gary Anderson said...

If Glen Beck hated the neocons and warmongers who also were in bed with Greenspan and the central bank, then he would have some credibility. Beck is only against the banksters where it benefits the Republicans, who are, with the exception of a few like Ron Paul, are also in bed with the banksters.

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