Connelly on Commerce

Terry Connelly is dean of the Ageno School of Business at Golden Gate University and is frequently quoted on business, financial, and economic issues by Bay Area local, as well as national, news media.

Expected passage this weekend of the omnibus Housing Bill by both Houses of Congress and a quick but quiet signature by the President finally puts a floor under the cratered housing finance markets in the US, but at what price?

Some estimate the cost to the Federal taxpayer in the zip code of $25 billion, but that’s just an early guess. The final legislation does not authorize the Government to buy equity or even preferred stock in Fannie Mae and Freddie Mac, but it does authorize an open-ended extension of credit to support their operations, which may or may not be utilized — there is some sense that the option of going to the Federal Reserve’s discount window — now open to the GSE’s — may be more appealing and have fewer rating-negative consequences for the GSEs’ existing subordinated lenders: no small matter these days when it comes to market perception of financial institutions’ outstanding obligations. 

Could this new extension of Governmental credit to a troubled pair of financial institutions, moreover, again produce what we might now call another “Bear  Steans Effect” — namely, a run on the debt obligations of the very institution the credit extension was designed to save? There are some signs of that in the bond and preferred market already.

Not to say that the Government has any choice; the “last resort” has finally come to the fore: the Federal Reserve can do no more good for the housing finance collapse by cutting interest rates further, and is even  considering raising them. This could in the short run play havoc with remaining adjustable-rate mortgages (although in fairness any such increase would be designed to tamp down inflationary pressures affecting the long-bond rates that are the benchmark for fixed-rate mortgages, which right now are trending upward. The main point is that the Fed itself is in a bit of a fix, and the new housing legislation may give it some decisional breathing room.

In addition, the provisions of the Act that expand the lending limits (up to $625,000) and capacity (by $300 billion) of the GSE’s clearly provide an absolutely necessary base for any recovering in the housing finance market, where the securitization process (which tends over time to hold interest costs down) is completely shut down, and where the non-GSE banking institutions are all but out of the market themselves because they have no place to off-load the mortgage paper through securitization.

In short, the GSE’s are now about the only mortgage-writing game in town, and they are at least in the game with a new Government backstop that provides a more clear commitment of the Government to stand behind them — not quite an official “‘full-faith-and-credit” pledge, but a pretty good commercial “keep-well”‘ agreement, where the only real risk is Federal bankrutcy or future changes in legislation. And the only time we’ll know the real cost of this new arrangmenet is when the next market “wild pitch” at Freddie or Fannie goes “all the way to the backstop” — but at least there is now a well-constructed backstop, so the game maybe can resume.

I say “maybe”  — because the housing finance game really can’t get back to anywhere near normal with the GSE’s as the only real lenders. At some point, the banks have to start ledning again, at economically reasonable rates. And that is where the risk lies for now.

Hopefully the very existence of new Federal commitments will be enough to put a floor under the price deterioration of currently outstanding mortgage-backed securities, so that our beleaguered financial institutions no longer will need to keep increasing their loss reserves and related quarterly write-downs of existing holdings — which impair the amount of capital available for future mortgage (and other commercial) leanding activity unless the banks engage in further expensive or dilutive (or both) infusions of capital from  foreign sovereign wealth funds or, more likely, US hedge funds. The Federal Reserve is conspicuosly clearing the way for the latter at an abnormally quick pace.

Hopefully, also, the new legislation will enable a restart of the securitization mechanism for distributing mortgage paper to the broad financial community beyond banks and thrifts and Wall Street, at least for GSE-backed mortgages to start with. But for this to occur, there must also be a renewed confidence in both the underwriters and the rating agencies, and that will take some time. This truly is becoming a season of ‘hope’.

The question in the coming days will be whether the legislation may in the short run provoke further runs on the deposits of the most troubled domestic banking institutions, based on the perception which the new Housing Act seems to imply — that the “market-based” housing finance model that has served this country so well for the past two decades is now so broken that only the Federal Government can save it, and that in turn the whole banking business model itself must now be called in to question (at least for banks in hock up to their capital eyeballs in red mortgage ink).  

If ordinary folks begin to fear that there is no longer anything “Automatic” about an ATM unless it’s Government-issue, we’re all in trouble. Call it “reverse moral hazard” — not the likelihood that institutions will feel free to tempt fate by again plunging into heedless risk next time around, but that depositors will feel fear that there will BE no “next time around”.

After all, if you see a boat being bailed-out in the harbor, you have a tendency to cancel your cruise (and not book a new one).

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Terry Connelly is dean of the Ageno School of Business at Golden Gate University and is frequently quoted on business, financial, and economic issues by Bay Area local, as well as national, news media.

With all the focus on Freddie and Fannie (not to be confused with Brad and Angelina), we can lose sight of the bigger game — namely, that the economy is clearly not out of the woods, nor have the risks to the economy clearly receded, because the housing finance and financial institution crisis is neither contained, nor indeed over.

There will be renewed focus on inflation this week, to be sure. with the release of the latest PPI and CPI data, and this could again suggest that the Fed’s next move in interest rates will be up.
Certainly the usual band of hawks in and around the Reserve Board and on cable news will say so.

But the Fed must first finish the task of making sure the economy does not collapse into a deep and prolonged recession (which, of course, is one sure way to take care of the inflation problem — the monetary version of the “destroy this village to save it” strategy).

It may simply be the case that the broader economy, having been Fed (if you will) a diet of interest rates starting with a “1″ by the famed Dr. Greenspan, now requires a similar level of rates to begin to get well again. Thus keeping interest rates at a number starting with a “2″, even followed by a bunch of zero’s, just won’t do the trick, even if the level of rates is clearly “accommodative” or even “negative” to inflation as economists look at it.

Psychology has a role to play in consumer actions and sentiments, and in business strategy and investment decisions as well. If we needed one per cent interest rates to get well from the combination of the dot-com crash and 9/11, who is to say we don’t also need them to get well from the “perfect storm’ of unprecedented oil prices, the collapse of the hosuing market, and the credit and liquidity crisis that still prevails among financial institutions.

The Federal Government of course stepped in aggessively in both military and civil defense areas after 9/11, but it didn’t move to rescue the dot-com casualties — because their collapse posed no systemic threat to the whole financial system.

But Bear stearns and “Freddie and Fannie” did and do pose such a threat — although with the collapse of IndyMac, we now know that there is at least one financial institution that is not “too big to fail”. The question now, as one TV commentator cleverly put it this morning, is whether Freddie and Fannie are “too big to fix” — that is what the equity markets are now debating. The answer will affect the Federal Reserve’s August interest rate decision (near the first anniversay of the first of many Fed “about-faces” on rate policy in the past year).

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