Fed Now Aiming Policy at Soaring Asset Values?
Market Views of Comstock Partners, Inc.
Thursday, June 16, 2005
When Chairman Greenspan called the action of the long Treasury bond a “conundrum”, he wasn’t just another investor complaining about a wrong call. Recent words and actions by the Fed and other financial institutions strongly indicate they are more worried than they say about the bubbling housing market, and the declining yield on the long T-bond isn’t helping. As is well-known by now, the long rate is lower now than it was before the Fed started its 200-basis point increase in the fed funds rate over four years ago, something that Chairman Greenpan said was “without recent precedent.” In order for the Fed tightening policy to work and to avoid severe damage to the economy, long-term rates have to rise, meaning that the Fed cannot call a halt to its “measured” rate rise policy until this occurs.
The Fed’s current dilemma is a direct result of its policy, instituted in early 2001, of trying to avert the potential damage of the bursting stock market bubble by spurring a rapid increase in housing prices. The policy worked in two ways. First, the soaring home prices were converted to ready cash by means of hundreds of billions of dollars of cash-outs on mortgage refinancings. These cash-outs along with plunging savings rates and soaring household debt enabled consumers to maintain their spending patterns despite far below average gains in conventional wages and salaries. Second, since the recovery began in November 2001 a full 43% of the increase in private-sector employment has occurred in housing and housing-related industries. However, while the policy worked in the short-run, the long-term damage may be far greater than if the Fed had let the normal economic corrective cycle run its course.
How do we know that the Fed is now highly concerned? First, on May 16, in a joint press release, the Fed and a number of other depository agencies issued new guidance to promote “sound risk management practices for home equity lines of credit lines of credit and loans. The agencies found that in some cases credit risk management practices for home equity lending have not kept pace with the product’s rapid growth and eased underwriting standards.” The release then delineated a number of risky practices including interest only features; limited or no documentation of borrower’s finances; high loan-to-value and debt-to-income ratios; low credit risk scores; greater use of automated valuation models and an increased number of transactions generated through third parties.
Second, Fed testimony and speeches have also revealed increased concerns. When Greenspan testified before the Congressional Joint Economic Committee, the headline story featured his opening paragraph that economic growth was solid. It was little noted, however, that of 14 paragraphs in the testimony, six were entirely devoted to the housing problem. He referred to “signs of froth in some local markets where home prices have risen to unsustainable levels”, the acceleration of second-home purchases, and the greater role of speculative activity in generating the recent price increases. Greenspan also mentioned the dramatic increase in interest-only loans, and “exotic forms of adjustable-rate mortgages.” While the Chairman concluded that there was no “national” housing bubble, we all know where the “local” areas of “froth” are—the Northeast seaboard, Florida and the California coast as well as some major inland areas. In other words the areas of froth are the places with the highest populations and the highest GDP. Obviously, any puncturing of this froth, which is what the Fed is apparently trying to do, would have major national economic consequences.
Only six days later, on June 15, Federal Reserve Governor Kohn, a relative dove, followed up with another warning that the surge in house prices might not be sustainable and urged banks to shield themselves against unlikely but potentially harmful events. He stated that “The risk of rapid adjustments and unusual configurations of asset price movements is higher than normal.”
In our view the increased Fed concern about a severe problem that they themselves created indicates that the Fed is finally starting to aim policy at soaring asset values, unlike the policy they followed during the late 1990s stock market boom, when they felt rising asset values were none of their business. The big difference this time is that an out-of-control housing market propelled by heavy bank lending is a direct threat to the health of the entire banking system in a way that the stock market was not. Therefore the Fed’s focus is no longer only on inflation, but on soaring asset values as well, meaning that the tightening policy may last longer than the majority think. The problem is that even a mere cooling of the housing market, let alone a decline, kills the major impetus to the entire recovery since November 2001, and highly increases the probability of a recession and falling stock market with all of the associated risks to the fragile consumer debt structure.
© 2005 Comstock Partners, Inc.
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