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December 5, 2007

On Rescuing Housing: "Get with it, Mr. President"

William Gross explains why we need to rescue housing, and that fiscal, not monetary policy is the solution for struggling homeowners:

Why We Need a Housing Rescue, by William H. Gross, Commentary, Washington Post: During times of market turmoil, it helps to get down to basics. ... Financial institutions lend trillions ... among each other. The Fed lends to banks, which lend to prime brokers such as Goldman Sachs and Morgan Stanley, which lend to hedge funds, and so on. The food chain is not one of predator feasting on prey but a symbiotic credit extension, always for profit but never without trust that the money will be repaid... When the trust breaks down, money is figuratively stuffed into Wall Street and London mattresses as opposed to extended to the increasingly desperate hedge funds and other financial conduits. These structures in turn are experiencing runs from depositors and lenders exposed to asset price declines of unexpected proportions. In such an environment, markets become incredibly volatile...

The past few weeks have exposed a giant crack in modern financial architecture... While the newborn derivatives may hedge individual, institutional and sector risk, they cannot hedge liquidity risk. ... Only the central banks can solve this, with their own liquidity infusions and perhaps a series of rate cuts.

Should markets be stabilized, policymakers must then decide what to do about the housing market. Seventy percent of American households are homeowners. Granted, a dose of market discipline in the form of lower prices might be healthy, but forecasters are projecting more than 2 million defaults... The resulting impact on housing prices is likely to be close to a 10 percent decline. Such an asset deflation has not been seen in the United States since the Great Depression.

Housing prices could probably be supported by substantial cuts in short-term interest rates, but even cuts of 2 to 3 percentage points by the Fed would not avert an increase in interest rates of adjustable-rate mortgages; nor would they guarantee that the private mortgage market -- flush with fears of depreciating collateral -- would follow along in terms of 30-year mortgage yields and relaxed lending standards. Additionally, cuts of such magnitude would almost guarantee a resurgence of speculative investment via hedge funds and levered conduits. Such a move would also more than likely weaken the dollar -- even produce a run...

The ultimate solution must not emanate from the Fed but from the White House. Fiscal, not monetary, policy should be the preferred remedy. In the early 1990s the government absorbed the bad debts of the failing savings and loan industry. Why is it possible to rescue corrupt S&L buccaneers yet 2 million homeowners must be thrown to the wolves today? If we can bail out Chrysler, why can't we support American homeowners?

Critics warn of a "moral hazard." If we bail out homeowners this time, they claim, it will just encourage another round of speculation in the future. But there's never been a problem in terms of national housing price bubbles until recently. Home prices have been the most consistent, least bubbly asset aside from Treasury bills for the past 50 years. Only in the past few years, when regulation has broken down, when the Fed has failed to exercise appropriate supervision, have we seen "no-doc" and "liar" loans and "100 percent plus" loans. If you enforce regulation, you'll have no problem with moral hazard.

This rescue, which admittedly might bail out speculators who deserve much worse, would support millions of hardworking Americans. ...

Get with it, Mr. President. This is your moment to one-up Barney Frank and the Democrats. Create a Reconstruction Mortgage Corporation. Or, at the least, modify the existing FHA program, long discarded as ineffective. Bail 'em out -- and prevent a destructive housing deflation that Ben Bernanke cannot avert. After all, you're the Decider, aren't you?

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