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To counter the increasing demands that government reduce its
micromanagement of the economy, last week the Obama Administration offered a
fig leaf in the form of a white paper entitled "Reforming America's
Housing Finance Market." In addition to marking the official end of the
Bush era "ownership society," where increasing the level of home
ownership was a national priority, the document contains a recommended
regulatory overhaul of the Federal Housing Authority (FHA) as well as Fannie
Mae and Freddie Mac (together known as Government Sponsored Enterprises
"GSE's"), that intends to bring the share of government owned home
loans from the current 95% to 40% over the next 5-7 years.
In the report, the Obama Administration makes the important
admission that government interference in housing had dangerously distorted
the market. And, while the goal of reducing the government's footprint in the
housing market is certainly laudable, the reform plan is not only too little
too late, but fails miserably to address the nucleus of the problem. Even if
all the recommendations are adopted, the government would actually extend its
explicit guarantees to bail out failing lenders. Most importantly, the
proposal completely overlooks the most significant government distortion of
the housing market: the Federal Reserve's manipulation of interest rates.
Thus, this plan will insure that government's role in the mortgage market
will likely expand in the years ahead.
Banks are in the business of borrowing on the short end of the yield
curve and lending on the long end. Since interest rates are generally lower
for shorter time durations, banks make profits by capturing the spread. But
if the gap between long term and short term rates narrow, or sometimes vanish
completely, banks have a much harder time operating. Rapid and dramatic
changes in interest rates also expose banks to money losing risks.
In a free market, whenever the supply of savings contracts the cost
of money tends to increase. Those rising interest rates curb the demand for
borrowing and increase the propensity to save. Conversely, increased savings
rates lower the price of money, thereby encouraging more borrowing.
Consequently, in a free economy market forces tend to stabilize interest rate
volatility. However in the United States interest rates are anything but
free.
When interest rates are set by a few people behind closed doors, as
they are by the Federal Reserve, massive distortions can occur in the supply
demand metric. For example, the S&L crisis of the late 80's and early
90's was brought about by the loose monetary policy of the 70's. Rising
interest rates, which were a direct response to rising inflation, soon found
S&L's paying out more on their short-term borrowed funds than they were
collecting on their long term assets. The consequences for those imbalances
caused by our central bank rendered nearly one thousand banks insolvent.
To mitigate this problem, early in the last decade banks began turning
more and more to securitization as a way to unload the mortgages on their
books by packaging and selling loans to outside investors. Not only does
securitization bring in fees and reduce banks' risk exposure but it also
sucks in more capital to the real estate market, while increasing financial
sector profits. It's no wonder that the securitization market grew to over
$10 trillion in the U.S. before the credit crisis of 2008. On paper this was
a good solution to the problem, but additional government involvement in the
securitization market threw in a monkey wrench.
Given the size and diversity of the investment market in the U.S. and around the world, there was adequate private demand for securitized mortgages.
With relatively low risk and more generous yields than government debt,
pension funds and other institutional investors bought heavily. However, as
the Federal Reserve continued to lower rates and as the government engineered
housing boom finally went bust, this private label demand dried up almost
completely. The GSEs now provide financing for 9 out of 10 mortgages.
Therefore, the real estate market today is virtually 100% distorted and
manipulated by government forces.
Treasury Secretary Geithner--the President's main pitch man for the
program--touted the proposed solution of a hybrid federal reinsurance
plan that would include a standing federal catastrophic reinsurer for private
guarantors of mortgage-backed securities. The government has already clearly
shown that its erstwhile implicit guarantee is now in fact explicit for GSE
debt. That condition would remain intact. However, now government involvement
would also morph into an explicit guarantee to reinsure private label
mortgages. Therefore, in typical government fashion, the proposed reforms are
merely a repackaging of the previous sham. Even if the plan were to be
successfully carried out, the GSEs would still account for nearly half of all
mortgage financing. Only now the government would also back private insurance
for private label MBS with yet another explicit guarantee in case of
emergency. Who can doubt that such conditions will inevitably arise? As to
how this can ever satisfy the need to remove moral hazard or getting the
government out of the housing market is beyond me.
In other words, there is no meaningful governmental withdrawal
from the market. Most importantly, the plan does nothing to address the Fed's
role in making interest rates much lower and more volatile than they would
otherwise be. Unfortunately the housing market will remain in government
control for years to come and another real estate crisis will inevitably
occur
Michael Pento
Senior Market Strategist
Delta Global
Advisors, Inc.
Delta Global Advisors : 19051
Goldenwest, #106-116 Huntington Beach, CA 92648 Phone: 800-485-1220 Fax:
800-485-1225
A 15-year industry
veteran whose career began as a trader on the floor of the New York Stock
Exchange, Michael Pento recently served as a Vice President of Investments
for GunnAllen Financial. Previously, he managed individual
portfolios as a Vice President for First Montauk Securities, where he
focused on options management and advanced yield-enhancing strategies to
increase portfolio returns. He is also a published economic theorist in
the Austrian school of economic theory.
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