The US housing market is the most important marginal asset class globally. In the past 12 weeks, two important developments have occurred which have increased the value and the funding viability of the housing market. In another example of how policy is driving asset prices, the Federal Reserve and the Bank of International Settlements (BIS) have moved the goal posts and have given equity investors (yet again) a ‘get out of jail free’ card. These moves are very important and will have positive benefits for asset prices. This rally is NOT about avoiding the fiscal cliff. It is about policies implemented by regulators to maintain the recovery in US housing prices. They may just pull it off.
The United States has a stock of about 72 million homes, not counting apartments. About 53 million of these homes have existing mortgages. If we include apartments and condominiums, the value of the stock of homes is about $55 trillion. This is larger than the flow of GDP of the entire world. It is also about 16% of total global wealth if we add up debt, equity, real estate and currency. It is a really big number and it counts.
A significant portion of the existing mortgages in the US market were originated between the insane bubble years of 2002 and 2006 through Fannie Mae and Freddie Mac, government-sponsored enterprises (GSEs) of the federal government which had scandalously little capital to support any slightest drop in housing prices. SO, when housing prices did, in fact, drop starting in 2007-08, these GSEs automatically collapsed and had their capital wiped out.
So, the $7 trillion in hitherto liquid mortgage-backed securities -- with which these GSE funded themselves -- automatically froze up and the whole alphabet soup of MBS/CDO/CMO mortgage derivatives collapsed. Many, many people saw this coming, but, as Gretchen Morgenson notes in her terrific book Reckless Endangerment, the GSEs were using their well-financed and powerful ‘mafia’ lobbying arm to defang regulatory agencies and discredit the Cassandras.
So, the only entity left with the firepower to buy these MBS and get the system to function again was the Federal Reserve. And once again, the Fed started buying MBS in November and promised to buy more than $50 billion/month until the end of 2013. This causes interest rates on mortgages to fall, creates liquidity in the real estate system and removes the number one fear of the financial world, namely, how in the heck will the Fed unwind its balance sheet by shelling more than $1 trillion in MBS without causing a crash in prices and a spike in mortgage rates. They just did it. The BIS has ruled that banks may now hold MBS as “liquid securities”, the problem is solved.
The BIS changed its rules recently on what can be counted as liquid for a bank’s balance sheet. This is important, because “liquid” instruments (things that can be ‘quickly turned into cash’) are cheap and easy to hold, and are therefore desirable. These rules were significantly relaxed by the BIS recently and will now allow “liquid securities” to include government securities AND (you guessed it) mortgage backed securities. So, the BIS has just created a VERY large parking lot of MBS on the balance sheets of the banks. So, the Federal Reserve will, I presume, begin to move its inventory of MBS from its own balance sheet to the balance sheet of the private banks.
So, housing prices recovered by 4% in the latter part of 2012. This has profound effects on sentiment, consumer confidence and actual prices. And, because this stock of housing is so large, it has an automatic effect on global asset prices. All boats were lifted. And I think they will be lifted into the spring. People are underweight equities and own too many bonds. So, a slight shift in asset allocation could go a long way. China is one of the worst performing stock markets over the past five years, so the SHCOMP should play catch-up more than most.
When it comes time for the Federal Reserve to exit its own “price-keeping operations” for the property market, it can hand the baton to the banks. This is a really big get out of jail free card for the US financial system. The BIS just made a ready market for MBS, so the deep fears of a log jam as the Federal Reserve sells its huge inventory of more than $1 trillion of MBS, there is a place on the balance sheet of the private sector for these MBS to go.
Policy makers reserve the right at any time to change the goal posts for the sake of financial stability. Investors should heed these policies. This will make mortgages attractive to banks now, even if MBS are really NOT liquid. Oh well.
With actions like this, the Fed and the BIS have removed default risk from the system. When these entities step in and move the goal posts to add liquidity or make it easier for banks to support risky assets, those assets which are most at risk of default receive the greatest benefit. Where was the greatest fear of default at the end of 2012? The French banks. And voila! They have exploded up, and are among the best performing banks globally. So have Indian banks, and several UK banks. It is not worth chasing after these. The US banks deserve a leg up after all the hard work of recapitalization and rebuilding deposits.
Bernanke said it well in 2006: Do anything – anything! – you need to do in order to avoid a depression. Because once you are in one, it is damn difficult to get out. Just ask Japan.
Paul Schulte is a Senior Fellow at the Fletcher School of Law and Diplomacy at Tufts University. He is an Adjunct Assistant Professor at both The Hong Kong University of Science and Technology as well as FGV in Rio de Janeiro, Brazil.