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This article explores the immediate and long-term effects of the Federal ReserveThe central bank in control of regulating the U.S. financial and monetary system.’s (the Fed’s) purchase of $1.25 trillion in mortgage-backed bondsAn assetA valuable item which can be converted to cash by its owner.-backed security representing a claim on the cash flows received on a mortgage loan. (MBBs) during 2009 and 2010, and the current and future benefits of Fed purchases for homebuyer financing.
The federal responsibility to regulate
America’s central bank is responsible for limiting the harmful effects of falling prices and unemploymentWhen an employee loses their job, resulting in no income. associated with the nation’s reduced spending power in times of economic crisis. While many of the painful signs of a recessionAn economic event triggered and controlled by the Federal Reserve to maintain the sustainability of economic growth. are beyond the government’s direct control, the U. S. Federal Reserve (the Fed) does have the crucial authority to alter interest rates through monetary policyThe Federal Reserve's use of short-term interest rates and other infusions and withdrawals of dollars in circulation to control pricing and employment in the economy. and affect the recession’s outcome by doing so.
The Fed is able to lend to banks at a lower cost by printing and increasing the amount of money available to businesses and consumers. A larger supply of money encourages banks to lend and — perhaps most importantly — helps to fight the possibility of consumer and asset price deflation in the market.
While right-wing inflationThe price changes over time in consumer goods and services, quantified in the consumer price index (CPI).-hawks promulgate fear-laden demagoguery about the dangers of inflation simply because the Fed prints money (which—don’t forget — is its job), first tuesday asserts that consumer inflation is not, and will not soon be, a concern for the U.S. economy or the Fed. On the other hand, value deflation —should it develop in prices — is a pernicious bane that threatens from the shadows in times of economic crisis. Japan’s “lost decade” of the 1990s is attributed to consumer and asset price deflation, and our Fed’s efforts to avoid a similar fate in our economy are to be commended. [For more on the realities of inflation, see the October 2010 Article, Deflation’s push on the real estate recovery.]
How, then, can the Fed continue to fight price deflation and job loss after it has already reduced interest rates to near zero? The answer: by buying long-term bonds from banks and private investors — a process which, in turn, requires the minting of new money for the purchase.
Between late 2008 and early 2010, the Fed purchased a total of $1.3 trillion in mortgage-backed bonds (MBBs) from Fannie MaeA government-sponsored entity operating in the secondary mortgage market. (Fannie) and Freddie Mac (Freddie), as well as bonds insured by Ginnie Mae. The Fed has since announced it intends to purchase an additional $800 billion in bonds. This federal bond-purchasing process is referred to as the Large Scale Asset Purchase (LSAP) program.
The LSAP program is intended to depress interest rates on long-term yields (such as 30-year mortgages) since short-term interest rates have already reached their lowest possible level. In theory, this move will prove useful in multiple ways.
First, the Fed’s extensive purchases will indicate to lenders and buyers that the Fed fully intends to maintain short-term interest rates at their current low level. Restoring investorA purchaser who holds a property long-term on a buy-to-let basis as an income-producing investment. Contrast with a speculator who buys-to-flip a property for fast profits, rather than annual income. confidence will support private investment in business and real estate, which is necessary for a stable recovery.
Restoring investor confidence is necessary for a stable recovery.
Second, the purchase of bonds will immediately remove loans from the books of lenders and investors. That money will be injected back into the market via bank reserves and deposits, and made available for investment through lending.
Third, and most importantly, long-term bond purchases by the Fed are expected to reduce the supply of long-term bonds available for investors, thereby raising bond prices and lowering interest rate yields. In short, banks see their cash reserves and deposits increase and lower the interest rates they charge, thus promoting private investment of borrowed funds. So far, signs indicate that these hopes are justified.
According to the Federal Reserve Bank of San Francisco (FRBSF), the LSAP program is likely to lower the national unemployment rate 1.5 percentage points by 2012: a total of approximately three million jobs created nationwide. That translates into roughly 300,000 additionally employed in California during 2011 (the UCLA Anderson School of Management predicts 200,000 in 2011). California real estate brokers (and the Governor) need around 400,000 new jobs annually for a period of at least four years to start smiling again.
Employment is the single most crucial factor determining a homebuyer’s ability to obtain and retain a home, and the LSAP’s role in promoting employment is thus vital. [For more information on the FRBSF’s analysis of the LSAP program, see the FRBSF Economic Letter 2011-03.]
Although it remains uncertain, the FRBSF finds it likely that the Fed’s asset purchases have played an important role in preventing harmful deflation. The FRBSF indicates the current level of inflation in the United States is approximately one full percentage point higher than it would have been without the LSAP program. Given the still-low level of inflation, this means that we would currently be approaching deflationary levels without the LSAP. [For current levels of inflation, see the first tuesday current Market Chart feature, The Consumer Price IndexThe Consumer Price Index measures and tracks the rate of consumer inflation. This is presented as an index of fluctuations in the general price of a wide selection of consumable items, goods and services.]
Results for homebuyers
While homebuyers have benefited from artificially-low mortgage rates brought about by the LSAP program, many are left wondering what other effects the Fed’s asset purchases may have upon the real estate market. After all, the Fed’s extensive resources were largely devoted to the purchase of real estate mortgage debt, especially 30-year loans produced by Fannie and Freddie. In fact, the Fed’s purchases in the LSAP program succeeded in single-handedly sustaining Fannie and Freddie by buying all the bonds needed to fund the mortgages made or guaranteed by both lending institutions in 2009 and early 2010.
As an immediate side effect, housing bond market investors regained a small level of confidence — a good thing for the economy at large.
Meanwhile, 1,500,000 jobs were lost in California through January 2011, and homeowners and homebuyers found themselves wondering what the Fed’s massive bond purchases had done to help them. Did the newly recapitalized lending institutions offer lower rates to homebuyers? Were lenders more or less willing to offer new loans? Who, in the end, actually benefitted from the Fed’s purchase of all these bonds?
The answers to these questions have been examined in a recent report from the Federal Reserve Bank of Boston (FRBB). The FRBB examined the results of the Fed’s vast purchase of bonds, in an effort to determine whether homeowners were able to benefit from the Fed’s largesse.
They discovered that interest rates for homebuyers were dramatically reduced immediately after the Fed’s first purchase of bonds in November 2008 — some by as many as 40 basis points. This reduction was not uniform, though, since interest rates rose on mortgages not funded by those bonds (i.e., jumbo loans).
While the FRBB used data from across the nation, the study was focused on California. The results sketch a rough picture of the mortgage refinance situation circa 2009 and 2010 in our home state. As one might expect, the improvement in rates was generally limited to borrowers with high credit scores. [For information on the fallacy of using credit scores to gage creditworthinessan individual’s ability to borrow money, determined by their income and previous debt payment history., see the June 2010 first tuesday article, The FICO score delusion.]
The drop in interest rates was especially prominent for homebuyers who negotiated to pay origination fees on their loans in cash, as opposed to loans where the homebuyer did not pay cash for the fees and either added them to the loan amount or paid an above-par rateThe interest rate without the addition of a yield spread
premium or discount points..
Upon implementation of the LSAP program, the number of homeowners looking for refinance loans tripled immediately, indicating the LSAP was effective in stimulating the mortgage refinancing (refi) market.
However, news of the Fed’s asset purchases did not succeed in increasing the number of homebuyers applying for mortgage loans. In the aftermath of the market crash, the hype of the Fed’s large-scale purchase of home loans did little to stimulate interest in buying homes.
In conclusion, it appears the Fed’s decision to purchase MBBs was a success for owners with sufficient credit and positive equity in their homes; in other words, the wealthy. The LSAP program successfully boosted the ability and motivation for many such homeowners to refinance.
This is good news, since refinancing at a low interest rate is a positive choice that dramatically lowers homeowners’ monthly payments, putting more disposable income in their hands to spend.
However, many homeowners refinanced 30-year mortgages with 15-year mortgages without increasing (or decreasing) their payments — many have even succeeded in decreasing their rates (good for them, but not helpful for the economy). [For more on 15- and 30-year interest rates, see the October 2010 Article, The abuses of lower interest rates.]
On the other hand, benefits were largely limited to those with high credit scores and a positive equity in their home; again, the wealthy. In the meantime, those who had the greatest need to refinance have been unable to do so on improved terms. This includes negative equityThe condition of a property owner owing more on a mortgage than the current fair market value of the encumbered property. homeowners, who still make up 25% to 30% of homeowners in California.
Second wave bond purchases
Two federal authorities have the power to ameliorate a mortgage crisis: Congress and the Fed. When Congress fails to create employment or take other actions through legislative incentives designed to stimulate home sales, the Fed has both the ability and responsibility to make up for Congress’ shortcomings. To fill the present vacuum left by congressional inaction, the Fed has already begun yet another round of large-scale asset purchases (referred to in government circles as quantitative easingThe purchase of government bonds by the Federal Reserve (the Fed) to drive down interest rates and increase liquidity. (QE), with this second round popularly termed QE2).
The QE2 has an effect on the U.S. economy roughly similar to the Fed dropping the discount rateThe interest rate the Federal Reserve charges banks and thrifts who borrow funds directly from the Fed to maintain reserve requirements. by approximately 0.66%: a necessary stimulative measure if they are to encourage borrowing, investing and hiring. Meanwhile, the Fed is unable to actually lower rates: the discount rate currently sits at an extremely low 0.55%, and any drop would bring them practically to zero or below. The Fed can “go negative” with rates by lending dollars now and being repaid a lesser amount sometime in the future: a move that will cause lenders to borrow funds and resume lending practices, but will cause inflation hawks to go crazy.
The QE2 is a necessary stimulative measure to encourage borrowing, investing and hiring.
While the FRBB’s article demonstrates that a second round of asset purchases is unlikely to have a significant effect on low-income homeowners seeking to refinance, QE2 is desirable for an entirely different reason. The Fed’s purchase of bonds acts as an injection of cash into the market. This inflationary measure works to prevent deflation, which would be far more catastrophic than the more easily-controlled. This measure is absolutely necessary to improve employment (by increasing the capital available to businesses) and avoid deflation, both of which are on the cusp of falling backwards. As all are aware, a fall in employment inevitably leads to a corresponding fall in the housing market. The recovery remains far too tenuous to be risked unnecessarily.
The Fed has an endless supply of money to lend, always gets it back, and can never go broke. While the Fed’s purchase of MBBs seems extravagant to the uninformed, it is important to understand that the Fed’s money-printing costs the government absolutely nothing, in contrast to a stimulus package produced by Congress to spend taxpayer money.
The fear the Fed inspires among a “no-change” Congress and some hedge fund investors is based upon an unfounded but persistent belief that inflation arises every time the Fed increases the amount of money printed. No such threat of inflation is present or immediately foreseeable, and any congressional action to prevent the Fed from flooding the market with money to get the economy going would be both uninformed and harmful.
Remember, the Fed always gets its money back, even if it were to drop it to consumers from airplanes. [For more on the Fed’s role in preventing inflation and deflation, see the November 2009 first tuesday article, The Fed to the Rescue.]
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