March 09, 2004

Side Effects: Quote of the Day

Here's a speech Jack Guynn, the President of the Atlanta Fed gave last week on real estate and interest rates. It's the first time I've heard a member of the Fed worry publicly about excess capacity in the housing market, and then go on to identify it as an unintended side affect of the low interest rate environment. "But just as a doctor shouldn't overmedicate the patient, one always should be sensitive to the potential for unintended side effects of maintaining an accommodative policy for too long. Put differently, if my forecast for robust economic growth materializes, then, at some point, a fed funds rate of 1 percent will no longer be the best policy." My question is this: will a Fed funds rate of 1 percent be the best policy if the unintended side effects (excess housing capacity) keep building up and the Fed's forecast for "robust economic growth" does NOT materialize? What will the Fed do then? Raise rates anyway to pop the mortgage bubble? Doubtful. But two weeks ago we have Greenspan fretting in front of Congress about the systemic risk of the GSEs. And why not? With assets of over $1.6 trillion (mostly mortgages), Fannie and Freddie are larger than Citibank. According to the FM Policy Focus, if Fannie and Freddie defaulted on theiroustandingg debt, a taxpayer financed bailout would cost $16,434 per American. Of course it's not just Fannie and Freddie at risk. It's anyone who owns a bond sold by Fannie and Freddie. A lot of people own GSE bonds. The FDIC recently reported thatf ederally insured institutions own 17% of Fannie and Freddie's $1.8 trillion in direct debt obligations. But that's not all. Over 40% of the $1.9 trillion mortgage pool argument (bonds guaranteed by the GSEs) are owned by Federally insured institutions. One way or another, taxpayers are on the hook for at least some of the fallout from a GSE default. And then there's housing and real estate pricesthemselvess, which havebenefitedd so much from the GSE-financed boom. Today, I'll let Fed President Guynn have the last words. "At the risk of bringing this caution closer home to you and your businesses, let's think about commercial real estate. Coming off the building boom of the late 1990s, the economic downturn in 2001 was an unpleasant surprise. Office vacancy rates in the Atlanta area swelled to well over 20 percent as businesses began to slash payrolls and emptied large amounts of office and industrial space. "As it happened, low interest rates eased carrying costs and encouraged ongoing investment despite the high vacancies. I expect the Fed's accommodative policy is popular with many in this room, but some in your industry have stressed to me that at some point it will be appropriate, and helpful, to allow interest rates to return to more normal levels so that the market sorts itself out in an orderly way and returns to balance. As I said earlier, I want to avoid a situation where businesses begin to assume that policy, which was put in place to deal with a temporary economic circumstance, mistakenly becomes incorporated into business planning as the normal policy environment. "Another example strikes even closer to home for me. My son, Mike, after some terrific years with Charlie Brown and Rick O'Brien in commercial real estate development, moved into residential development in 1997. If I think about the six years Mike has now been in residential development, I realize he has not seen a downturn in the business and in fact has been riding the wave of low mortgage rates and historical rates of home building. As you might guess, Mike and I have had some interesting father-son talks about the seductive lures of such an extraordinary period. I think, at least I hope, Mike understands that, as rates move back to more typical levels at some point, some part of his business may be vulnerable -- that part induced by temporarily low rates alone. I hope he and others in the business have not assumed in their long-term business plans that this extraordinary period will continue indefinitely. And let's hope they are not creating new pockets of excess capacity that will have to be worked off as conditions return to normal." Okay, I was wrong. I'll take the last word after all. My forecast is that there is more to worry about than the pockets of excess housing capacity, although that could certainly be a catalyst for the inevitable correction. The biggest pocket of excess capacity itself is the mortgage lending market and the bonds of the GSES, now owned by so many Americans, albeit unwittingly. Working off that excess will be anything but normal.


Post a Comment

<< Home