(March 24, 2008) – Today a good thing happened. To help thaw the frozen mortgage markets, the Federal Housing Finance Board will allow regional U.S. banks in the Federal Home Loan Bank system to increase their holdings of agency MBS–mortgage-backed securities issued by Fannie Mae and Freddie Mac–by $150 billion for a period of two years. This roughly doubles the $150 billion of mortgage-backed securities that banks can already buy under existing rules. This should improve liquidity in the $4.5 trillion market for agency MBS that is the ultimate home for the bulk of mortgages. You can read the full story by clicking here.
As I am sure you have noticed, I have been whining about the stimulus package since it was first announced. The package is old-religion fiscal stimulus, straight out of the textbooks. It is designed to fix a problem that we don’t have–people who won’t spend their money. The textbook remedy is to give them some more money to spend. This time it’s $600. Problem is, it never works.
If there’s one thing that Americans know how to do it is spend money, which is the flip-side of our legendary low savings rate. (I have personally witnessed my children spend $600 per hour with gusts to $1000.) This time the problem is not lack of spending, it is frozen capital markets. Investors have temporarily lost their ability to peer into the future to identify and value the cash flow streams embodied in mortgage-backed securities, asset-backed securities, corporate debt and equities. If the pension funds, endowments, insurance companies and other long-term investors are reluctant holders of our existing stock of securities there will be no home for the new securities that are created when lenders make new mortgages or new corporate loans. The supply of new financing for homes and businesses dries up. That’s when economic activity gets choked off.
Capital markets support GDP the same way a volcano on the ocean floor supports a tropical island. Without a functioning capital market the economy does not produce the goods and services we refer to as GDP.
So what should a policy maker do? Do things that burn through the fog, making future cash streams more visible and secure for investors. And do things to improve the depth and liquidity of the capital markets. Today’s actions were just that.
Maybe even more important, what should a policy maker not do? They should not do anything to make it even more difficult to understand the future cash streams embodied in a security. That includes granting special powers to sue investors, granting bankruptcy judges the right to change the terms of contracts and Congressional committees that conduct public lynchings for political gain.
Finally, don’t do temporary things. Temporary things don’t work in capital markets. When you buy a mortgage security you need to feel comfortable about looking 5, 15, or 30 years into the future. Security prices are present values of the entire cash flow stream. Temporary measures can increase uncertainty and make things worse. For example, in the original stimulus package there was a one-year, temporary increase in the size of a mortgage loan that can be packaged and sold by the agencies, after which the limit would return to its former, lower level. That means for one year mortgage lenders will be selling a product to investors–MBS comprised of large loans–that is already scheduled to be discontinued, leaving an illiquid orphan basket of securities in the market that would be very difficult to price. Increasing the limit of conforming mortgages is a very good idea but it should be done permanently, not temporarily. When I pointed this out to White House officials they didn’t think it would be a problem because markets are efficient. I think it is a problem.
All in all, however, recent actions directed at capital markets are having a good effect. Example: last Wednesday’s easing of Fannie Mae and Freddie Mac’s capital requirements, allowing them to buy an additional $200 billion in mortgage securities. That’s why the stock market is starting to smell a bottom. There are huge long-term values at today’s prices.