Page 1 of 3 CREDIT BUBBLE BULLETIN No exits
Commentary and weekly watch by Doug Noland
The surprising resignations on Friday of Egypt's Hosni Mubarak and Bundesbank
president Axel Weber are reminders of how quickly events and circumstances can
change. At the same time, we witnessed further indication of the snail's pace
of US financial reform.
We're now into 2011. The Fannie and Freddie accounting scandal emerged in 2004.
The mortgage crisis erupted in 2007. But Fannie and Freddie, along with the
ballooning obligations of the Federal Housing Administration (FHA), today
mortgage marketplace like never before. The Barack Obama administration last
week released its "white paper" on reform of government-sponsored enterprises
such as mortgage guarantors Fannie Mae and Freddie Mac that will surely have
little impact for some number of years to come. Democrats and Republicans
remain united in their determination to talk the obvious need for reform and
then do nothing. At best, everyone is stalling.
First, it was the Federal Reserve. After working studiously to create one, the
Fed tossed its vaunted "exit strategy" right into the scrapheap. They were to
have moved to reduce holdings and liquidity operations that had ballooned
during the 2008 financial crisis. Our central bank abruptly reversed course and
instead chose to significantly expand stimulus - even in a non-crisis
environment. Fed Credit has inflated US$189 billion in the past 14 weeks, with
market perceptions of "too big to fail" and moral hazard being further
There was also a popular movement to rein in extraordinary fiscal stimulus. We
had national elections, heated campaigns and an apparent mandate for an "exit
strategy" away from massive US deficits. Well, there has been talk and bluster
and, what do you know, additional stimulus - and no exit anywhere on the
horizon. The Congressional Budget Office estimates the fiscal 2011 deficit will
be the largest yet, in the neighborhood of $1.5 trillion. Fiscal reform joined
monetary reform in their patient wait for a better day.
For the Fed, it is apparently a case of the unemployment rate remaining too
elevated. For others in Washington (congress and the administration), the "no
exit" strategy is consistent with the historical interplay between politicians
and inflationism: once they (both) get going there is really never a convenient
time to back away. And that's why an independent, disciplined and well-anchored
central bank is absolutely critical. With our ("activist" and experimental)
central bank monetizing staggering quantities of federal debt, the markets
remain content to accommodate the government borrowing and spending binge.
In an interview with the Financial Crisis Inquiry Commission, JPMorgan Chase's
CEO Jamie Dimon referred to Fannie Mae and Freddie Mac as "The biggest
disasters of all time… that one was an accident waiting to happen." As someone
who warned about the dangers of these institutions going back to the 1990s, I
am particularly frustrated by another Dimon quote (from Bloomberg): "We all
knew about it, we all worried about it, no one did anything about it."
One could argue that the timing is right today for a GSE "exit strategy". After
all, the economy is expanding and housing markets have generally stabilized.
Moreover, there is these days quite weak demand for mortgage credit (total
mortgage credit continues to contract). The revitalized banking system could
easily handle today's mortgage financing needs. Yet, according to Bloomberg
data, GSE MBS issuance jumped to $450 billion during the three-month period
November 2010 through January 2011, with Fannie leading the charge. Why?
Mortgages have traditionally been an unattractive investment. When market
yields rise, the duration of your instrument extends as borrowers hold tightly
onto below-market mortgages. As an investor, you lose. And a lender will often
receive an early return of principal when yields decline and borrowers
gleefully refinance into more attractive mortgages. Here, you don't win.
Potential losses of principal from difficult to forecast credit costs and
losses also create considerable investor uncertainty, especially in periods of
rampant credit expansion and inflationary risks. If you're going to lend to
someone to buy a house in an arms-length transaction in an unstable
environment, you would demand a hefty risk premium.
No one today seems willing to live with anything close to hefty lending
premiums. So there remains an impetus to heavily intermediate - to "slice and
dice", securitize, throw on guarantees and insurance and, in the process
distort various risks (including credit, interest-rate and liquidity). This is
all done in the name of ongoing cheap mortgage credit - one way or the other
backstopped by Washington. No one is willing to tolerate the pain of real
One cannot overstate the role that the taming of (unwieldy) mortgage credit
risk over the past two decades has had on the US financial sector, the US
economy, the global financial system and the structure of the global economy.
The securitization - and effective nationalization - of upwards of $10 trillion
of US mortgage debt risk altered the rules of US and global finance. On the
margin, it allowed our massive current account deficits; it worked to
de-industrialize our economy; and, over time, unleashed our credit bubble upon
One could argue that there's now "no turning back". A strong counter-argument
would posit that the past 20 years of mortgage credit reform - the US mortgage
finance bubble - was a historical aberration (recalling John Law).
For years now I've dismissed notions of privatizing the GSEs. These gigantic
and meagerly capitalized institutions simply could not stand on their own,
least of all in a post-mortgage finance bubble/housing mania backdrop. Besides
- and especially after the policy actions of the past few years - the markets
would gladly assume an implied "too big to fail" government backstop. For now
and for the foreseeable future, any institution acting singularly as a mortgage
risk repository poses a systemic risk.
The private mortgage insurance stocks rallied sharply on Friday on notions that
these companies will benefit from reform. Friday's white paper suggested a
lesser role for FHA insurance and possibly additional reliance on private
insurance to protect Fannie and Freddie. Long-time readers know that I am no
fan of credit insurance. It tends to distort risk and exacerbate the upside of
the credit cycle, while providing no real protection when the bust arrives. As
appealing as it sounds, private mortgage insurance is not part of any long-term
solution to our festering mortgage crisis.
Passing meaningful GSE reform in the face of well-financed support for their
ongoing role in mortgage credit is anything but assured, even some years down
the road. Today from the California Association of Realtors (CAR): "A reduced
government presence in the mortgage market will raise the cost of homeownership
and make mortgages less available. Moreover, Congress needs to understand that
during economic downturns, the housing market needs government involvement to
ensure capital stability. History has shown the private market is incapable and
unwilling to step in during the hardest of times and meet the demands of the
nation's home buyers. CAR, along with the National Association of Realtors,
believes that Fannie Mae and Freddie Mac government-sponsored enterprises
should be converted into government-chartered, non-profit corporations."
Today's "white paper" provided no clear plan but instead offered several
proposals. And, from a Bloomberg article, "All three proposals would accompany
an end of taxpayer support from Fannie Mae and Freddie Mac…" I would caution
against any optimism that this financial black hole is losing its energy.
Indeed, I would argue strongly that not until the government finance bubble
bursts will it be possible to comprehend the true costs of the ongoing mortgage
crisis. The scope of this problem won't really be appreciated until the current
extraordinary fiscal and monetary stimulus has run its course; not until market
yields are left to adjust to less government intrusion and intervention; not
until inflated US income levels are weaned from massive government
expenditures; not until the requisite restructuring of the US economy is on
course; and not until private credit is able to make inroads into market-based
The Barack Obama administration and congress are content to delay a timely exit
from massive fiscal stimulus, fearing the economy might fall right back into
recession. The Fed is also content, worried of what an exit from quantitative
easing would mean for a marketplace that must muster the necessary liquidity to
fund intractable federal deficits at low interest rates. And I believe all of
Washington is content to defer any meaningful mortgage finance reform until
they perceive that housing markets have recovered. Yet it will take years - and
a huge increase in government-backed mortgage credit - to revitalize our
nation's housing markets. And this is why I refer to - and worry greatly about
- the unfolding government (Treasury, Federal Reserve, and the GSEs) finance
Returning to Mr Dimon's comments from above, my guess is that the head of
JPMorgan and many other persons of influence have similar thoughts about
rapidly expanding federal obligations as they did previously with the GSEs. As
we witnessed with Fannie and Freddie, the powers that be will not intervene to
repress a bubble, especially when it is viewed as providing near-term benefits
and rather nebulous longer-term risks. I have no doubt that the future holds
more crisis committees, inquests, and reports. There will be additional
questions about Fannie, Freddie, and new issues with the FHA and unmanageable
federal debt. I expect similar answers: "We all knew about it, we all worried
about it, no one did anything about it."