Federal Reserve Board policymakers, meeting today in Washington, face a terrible dilemma. They can’t do what needs to be done to stimulate a near moribund economy. And what they can do won’t help very much.
The dilemma stems from the core problems facing the economy, which slowed to 1.5 percent in the second quarter. First and foremost is the continued economic drag from government budget cuts, which has cost over 600,000 state and local public employees their jobs over the past 18 months and over 50,000 federal employees their jobs in the past year. Without those job losses, unemployment in the U.S. would be a half to a full percentage point less than what it is today, economists say.
The second major headwind facing the economy comes from Europe, where budget austerity and bond market turmoil have triggered deep recessions along the eurozone’s southern tier. That’s depressed U.S. exports, reduced the overseas earnings of U.S.-based corporations and created a worldwide climate of economic uncertainty that impedes spending and investment.
The Fed can encourage its European counterparts to take action. But it can’t pull the trigger.
The final and perhaps biggest headwind is the continuing near depression in the U.S. housing market, which is still operating at half to three-quarters of its pre-Great Recession peak. New housing starts in June totaled an annual rate of 760,000 units, about half the 1.5 million units registered in the mid-2000s. Sales of new and existing homes are running at about 4.7 million units a year, well below the 6 million units a year considered normal.
You would think the Fed has real power to intervene on the housing front, primarily through its ability to buy mortgage-backed securities and lower interest rates to stimulate the market. But as we’ll see in a moment, there are financial sector roadblocks to wielding that power in an effective manner.
Fed chairman Ben Bernanke directly addressed the fiscal issue in his testimony before both houses of Congress in July. He repeatedly implored legislators on both sides of the aisle to adopt a sustainable fiscal policy that would combine a short-term stimulus to get the economy moving again with a long-term plan that would bring the nation’s yawning budget deficits under control.
Instead, Congress kicked the can down the road and left businesses and the American public with the gnawing fear that renewed stalemate after the election will result in the government running the economy off a fiscal cliff -- a combination of large tax increases and budget cuts looms, which would inevitably lead to renewed recession.
How about the housing market? The Fed’s chief tool to provide help there would be a third round of quantitative easing that would achieve lower long-term interest rates by increasing the Fed’s purchases of mortgage-backed securities.
An aggressive move by the Fed on that front could succeed in lowering mortgage rates to 2.5 to 2.75 percent, a full percentage point below current levels and the lowest rates of the modern era. In theory, that should cause a rush of new home buyers to scoop up houses that are now selling for inflation-adjusted prices that in most parts of the country are about where they were in the late 1990s.
But high unemployment, stagnant incomes, especially for younger families, and fear that home prices could fall farther continues to depress new and existing home sales. And as events in other precincts of Washington on Tuesday showed, there are structural reasons why lower rates might not work in clearing up the twin plagues of the post-bubble era: foreclosures and underwater mortgages.
While foreclosures have gotten most of the attention, the single biggest deadweight dragging down housing activity is the 11.1 million American homeowners who are stuck with mortgages worth more than the value of their homes – so-called underwater mortgages. Fully 80 percent of these homeowners are not deadbeats. They make their payments every month – often at rates far above what is available in the current marketplace since they were acquired near the height of the housing bubble when first mortgages were close to 6 percent and second mortgages could be 7 percent or higher.
But when these responsible borrowers show up at the bank to refinance, they get turned away. They can’t get a loan because the appraised value of their homes is below the mortgage value. Often it is far below. A report issued Tuesday by the Federal Housing Finance Agency, which oversees Fannie Mae and Freddie Mac, said more than half of its underwater mortgages, and those two agencies back about 41 percent of the 11.1 million underwater loans, had loan-to-value ratios above 115 percent.
Some Congressmen are pushing FHMA to use leftover funds from the Toxic Asset Relief Program – the bank bailout bill passed in October 2008 – to write down the principle of mortgages where homeowners have remained current in their payments. But FHMA acting director Edward DeMarco rejected that idea on Tuesday.
“Given our multiple responsibilities to conserve the assets of Fannie Mae and Freddie Mac, maximize assistance to homeowners to avoid foreclosures, and minimize the expense of such assistance to taxpayers, FHFA concluded that (principle reduction) did not clearly improve foreclosure avoidance while reducing costs to taxpayers relative to the approaches in place today,” he said.
Clearly, the overseer of Fannie and Freddie is no different than the private banks and bondholders who own mortgage-backed securities. While they face some risk that underwater homeowners will walk away from their loans, 80 percent don’t. That means the lenders continue to benefit from the high cash flow from overpriced mortgages taken out at the peak of the housing bubble.
If these same homeowners could refinance at current rates – about 3.5 percent – it would save an estimated $500 to $750 per month per household in lower interest costs, according to a spokesman for Sen. Jeff Merkley, D-Ore., who has sponsored an alternative approach to the problem. His bill would replicate a depression-era housing refinance corporation that could sell federally-backed bonds (now costing about 2 percent a year) to raise cash to purchase the old loan. Charging the homeowners about 4 percent on the new loans would be sufficient to create a fund for anticipated losses while insuring that the program didn’t cost taxpayers anything.
Given the likelihood that the current Congress won’t act on his innovative proposal, Merkley last week pressed Treasury Secretary Timothy Geithner at a hearing on the Libor scandal to experiment with a pilot project for underwater homeowners. It will take a new Congress actually open to solving some of the nation’s pressing economic problems to get movement on the Hill.
“It would help reduce the remaining pressures that housing is putting on the economy as a whole,” Geithner agreed. “We’d be very supportive of progress in that area.”
“Underwater mortgage debt is strongly linked with weak consumption, high unemployment, and sluggish wage growth,” said Mike Konczal, a fellow at the Roosevelt Institute. “The blockage of prepayment has created a windfall for creditors in a weak economy with low interest rates.”
Congress and the White House could, of course, wait until home values return to pre-recession levels – in essence, letting the market clear on its own. Or they could devise a program that actually helps underwater homeowners – something previous programs have failed to do.
One thing is certain. One more round of the Fed lowering interest rates through quantitative easing isn’t going to get the job done.