Federal Reserve & Interest Rates

Despite the improved outlook for financial markets and the record low mortgage rates, many analysts are skeptical that this will result in a recovery of the housing market any time soon.  Still, this may slow the bleeding in the housing market as mortgage holders try to take advantage of low rates to refinance, potentially keeping them from adding to the problem by avoiding foreclosure in the future.

Unfortunately most banks are still operating under tight lending standards, so the people who will benefit the most in the short run are those with impeccable credit scores.  The big problem is that secondary security markets have yet to recover from the initial sub prime collapse and quite possibly never will.

So while the Fed’s decision last week to purchase mortgage debt from Fannie Mae and Freddie Mac will initially increase the amount of mortgage originations in the short run, the two GSEs as well as other lenders will likely find it difficult to rollover this debt due to lack of private investment sources.  It will take time for investors to regain confidence in mortgage securities and in the meantime credit expansion will be slowed.

There is pretty much going to be a fundamental change in how financial markets work and that’s not even taking into account the many changes that will occur once the government finishes it’s regulatory overhaul of the financial system.  For all intents and purposes the originate to distribute model that banks had been operating under for so many years is dead and buried and many analysts doubt we will ever see the level of private investment that is required to make that system worthwhile once again.

The government has tried to take up the slack in the short run but most people feel that’s all it is, a short term solution.  Think of it this way, banks borrow short but lend long and in the past banks repackaged their loans and due the build up of secondary markets over time and the ease of resale, these securities in essence acted as short term assets for prospective investors.

The concern for many banks is what happens once the government turns off the spout.  Ideally they would like to borrow as much as they can in the short term and build up capital because with interest rates as low as they are right now, obviously the expectation is that rates will rise sometime in the future.

A lot will depend on the slope of the yield curve and how it changes over time once the government’s intervention ceases.  Basically it’s a waiting game on what will happen first, the return of private investment in the financial system or the government’s well running dry.

Financial markets appeared to be headed in the right direction this week as mortgage rates fell to record lows and the stock market regaining some of it’s confidence.  While the low mortgage rates may spur a wave of refinancing, there is still a long way to go before the housing market returns to normal.

The key event that may start us on the road to recovery may have come last week when the Federal Reserve announced that it would commit $1.05 trillion to purchase a combination of mortgage and Treasury securities.  While foreclosure are still a major problem, the wave of refinancing will help a lot of households avoid that trap.

Right now the government is praying that we don’t see anymore major events that will disrupt markets once again.  For the most part it seems as if most of the fires have been put out but all it takes is one spark to push back the time frame for recovery back once again.

Economic cycles take time to play out and this one is no different.  Even if financial markets were to magically return to normal overnight, it will probably be at least a year before this recession runs it’s course.

The economy will likely shed jobs for some time with the damage that has already been done.  There is also the fact that it will likely take as many as three years for the economy to realize the full benefits of the recent stimulus package, although consumer spending should receive a boost within the next six months or so.

The federal government will be exerting more control over the economy for quite some time and businesses will have to operate under increased regulations and scrutiny.  This is another cycle in it’s own right, for the past two decades we saw a steady flow of deregulation of financial markets, to the point that many companies became so highly leveraged in the credit derivatives market that it put the entire economy at risk.

Although the government today announced plans for an overhaul of the financial market, that won’t happen overnight and the economy still faces considerable risk from all the unfunded liabilities and counter-party risk that has built up since the derivatives market exploded onto the scene earlier this decade.

Unfortunately history has already shown that while a government run economy may make things less risky, it will also make it less efficient.

The Federal Reserve announced on Wednesday that it would allocate an additional $1.05 trillion to purchase a combination of long term Treasuries and agency debt.  With interest rates pretty much at zero, much of the Fed’s focus has been on it’s balance sheet operations.

In these circumstances, the Federal Reserve will employ all available tools to promote economic recovery and to preserve price stability.  The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and anticipates that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period. 

To provide greater support to mortgage lending and housing markets, the Committee decided today to increase the size of the Federal Reserve’s balance sheet further by purchasing up to an additional $750 billion of agency mortgage-backed securities, bringing its total purchases of these securities to up to $1.25 trillion this year, and to increase its purchases of agency debt this year by up to $100 billion to a total of up to $200 billion.  Moreover, to help improve conditions in private credit markets, the Committee decided to purchase up to $300 billion of longer-term Treasury securities over the next six months.

For the short term,  mortgage rates are expected to hit their lowest levels since World War II.  While this should help spur the housing market, it will still be up to the banking system to meet the higher demand for credit this move will create.

There are also concerns in some circles about the long term inflationary impact because in essence the Fed is pretty much printing money to purchase these  securities.  After the Fed’s announcement, commodities had their biggest one day rally in months.

Much of the concerns is over how quick the Fed will be able to reduce it’s balance sheet once economic activity returns to normal.  It is also likely that the Fed’s balance sheet will continue to grow since it seems apparent that the administration will face increasing difficulties in seeking additional funds from Congress to deal with problems in the financial system due to the recent public outrage over executive compensation.

For the most part, little has been done up until now to deal with the problems in the housing market when compared to the attention being paid to the banking system.  The problems with both areas are related and it would be foolish to think you could fix one without dealing with the other.

Hopefully the fall in mortgage rates, combined with the Treasury’s plan to purchase toxic assets will be enough to finally turn around a housing market that has been in the dumps since 2007.